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Wednesday, January 09, 2013 2:46 AM


Yield Curve: Where To From Here? Extreme Complacency in Face of Bernanke Shift


After a somewhat lengthy hiatus, Curve Watcher's Anonymous is taking a good long look at the US treasury yield curve.

Treasury Yield Curve


click on chart for sharper image

QE Ending in 2013?

There have been three consecutive headfakes higher in treasury yields only to see yields plunge to new lows on repeated QE announcements by Bernanke.

Is the fourth time a charm? Certainly Bernanke is not about to hike interest rates as Greenspan did. But what happens to the long end of the curve if Bernanke simply ends QE later this year?

The question stems from Minutes of the December FOMC Meeting released last week.

While almost all members thought that the asset purchase program begun in September had been effective and supportive of growth, they also generally saw that the benefits of ongoing purchases were uncertain and that the potential costs could rise as the size of the balance sheet increased. Various members stressed the importance of a continuing assessment of labor market developments and reviews of the program's efficacy and costs at upcoming FOMC meetings.

In considering the outlook for the labor market and the broader economy, a few members expressed the view that ongoing asset purchases would likely be warranted until about the end of 2013, while a few others emphasized the need for considerable policy accommodation but did not state a specific time frame or total for purchases.  

Several others thought that it would probably be appropriate to slow or to stop purchases well before the end of 2013, citing concerns about financial stability or the size of the balance sheet. One member viewed any additional purchases as unwarranted.
Extreme Complacency in Face of Bernanke Shift

Steen Jakobsen, chief economist for Saxo Bank in Denmark reflects on the minutes of the latest FOMC meeting in his post on Tuesday Two Ways to Be Happy.
There were two ways to be happy: improve your reality, or lower your expectations ― Jodi Picoult, Nineteen Minutes.

We all know which method the market uses to be happy!

I have to admit I am still fighting to understand what I think was a dramatic change in FOMC Minutes, which it should be said, the Ivory Tower Wall Street banks are busy ignoring, but a few points:

It does reflect a change from the Fed. Is Bernanke trying to protect his legacy as Bruce Krasting cleverly suggests in his piece: Ben Bernanke is facing a legacy problem. The argument here is that Bernanke leaves in just over a year from now and wants to leave US Monetary policy closer to a "neutral stance" relative to the present "emergency levels". Greenspan did the same for Bernanke as he hiked rates from 1% to 6% over 22 months, trying to unwind the easing of monetary policy following the 2000 IT bust. Anyone inclined to ignore bureaucrats' need for securing their legacy only has to look at how Greenspan spent two to three years trying to defend his record while at the Fed after he left (with no success).

The risk-on vs. risk-off paradigm has changed.

Sure, the Fed is not going to reduce its balance sheet. Sure, the Fed can come back and do more, but.... the put is much weaker now on the market. Actually, as of now the Fed's balance sheet size is stalling, even getting smaller, and clearly from the minutes we gathered that some of the FOMC members are genuinely concerned about the size of the balance sheet. My take is that "everything being equal the put on the market is now trading at less than 50 delta forward vs. 75 delta before these minutes.

The markets are clearly reacting to this.

The move in the 30 Y US bond yield is quit dramatic(at least relative to recent years lack of upside risk). We saw 2.46% in July 2012 and are now trading at 3.08%. The move is even more puzzling considering that recently the US economy is going nowhere, if anything it's stalling.

I have commented earlier this week - Overconfidence is the new black - about the extreme complacency of the market. We entered 2013 with the notion that nothing could go wrong. The FOMC was accommodative, 2013 was going to be a transition year where investing was supposed to be on autopilot. But already in the second week of the year and, at least in momentum terms, the world's biggest monetary experiment is flagging. The market will deny it for probably a week or two more, but even in finance there is gravity.
Bernanke's Legacy Problem

Bruce Krasting notes Ben Bernanke Is Facing A Legacy Problem
The surprise of the week was not the goofy ending to the cliff. It was the minutes from the Fed.

The meeting in question took place on 12/12, just 23 days ago. Some very major announcements came as a result of that meeting. A new, and much more aggressive Fed policy was revealed.

The Fed said it would keep its foot on the monetary gas pedal until unemployment fell to 6.5%, and maybe even lower than that. The economic forecasts that the Fed released showed a consensus estimate for unemployment staying above the magic 6.5% until at least 2015. So that set a bar for any changes in monetary policy years into the future.

And then we get the minutes from the meeting where all these dramatic steps were taken. The minutes read completely different. What the hell happened?

Why would the Fed send one signal on December 12 and quite a different one on January 4? When it comes to the Fed, there is always a motive for its actions. The motives are not always clear.

I do believe this development is connected to the “legacy” issue. Bernanke’s term at the Fed will set many historical precedents. To a significant extent, history will judge Bernanke on what he did while chairman of the Fed. But the books will also look at what happened after he left.

I believe that Bernanke would very much like to leave his successor with a Fed that had policy choices. As of today there are no options left.  Just more useless QE. I doubt that Bernanke wants to exit with the Fed’s foot planted firmly on the gas pedal. The next guy does deserve a cleaner plate than now exists.

Is the Legacy factor influencing Bernanke? I think it has some sway in his thinking. Consider what Greenspan did before he left. After years of soft monetary policy he ratcheted up the Federal Funds rate 17 times in 22 months.

Clearly, Greenspan tried to get monetary policy back to neutral before he left, I don’t see any reason why Bernanke would think differently. Are we watching a repeat of history? At a minimum, his legacy, and where he wants the Fed to be when he leaves,  is part of Ben’s thinking today.

Reading the Fed’s tealeaves is a bit of a fool’s game. The chances of being right are about 50-50. But for the sake of discussion, assume that the Fed was telling the truth this past week. Monetary policy will change over the course of the year. It will go from 4th gear and full gas, to “neutral”.
Reflections on the Fed's Balance Sheet

Bruce notes that there are two schools of thought regarding the Fed's balance sheet.

  1. The size of the Fed's balance sheet is what matters most when it comes to measuring economic stimulus
  2. The direction of the Fed's balance sheet (the daily, weekly, monthly flows) is what matters most

Bruce opines that most Fed watchers believe that size is what matters. He sides with ZeroHedge that the flow is what counts. I agree as well, especially at policy turning points.

Neither Zerohedge, nor I, nor Bruce, think the Fed is going to reduce its balance sheet by selling assets. It would put too much upward pressure on interest rates. Steen Jakobsen is in that camp as well.

Yet, if we are correct that flow is what matters, then the Fed going from huge balance sheet additions to a neutral stance, ending QE would be a big thing. This holds true whether the Fed winds down slowly (the most likely scenario) or the Fed halts abruptly (which could put an even larger shock on the system).

Guessing Game

Of course, all of us may be in fantasy land. Perhaps Bernanke has no intention of halting QE in spite of what the minutes suggest. That was indeed my first thought when I read them.

However, if it's not a headfake, both the stock market and the bond market could be in for quite a rough ride given the extreme complacency and the "belief bubble" that the Fed can do no wrong.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

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