his article originally appeared in the online edition of
Barron’s on 30 July 2013.
Calm largely returned to the bond market in July following a bout of turbulence in June. Volatility declined across the broad spectrum of fixed income assets, with interest rates and credit spreads falling from their highs, in some cases dramatically. Flows have also turned positive in many market segments, particularly for high yield and bank loan securities.
This shouldn't come as a surprise. PIMCO believes the turbulence was built more on technical factors than fundamental ones, with pipelines becoming clogged by decreases in the ability and willingness of financial intermediaries to warehouse risk during a time of stress when investors go to sell all at once. Throughout, there were no threats of what matters most to bond investors: either an increase in inflation or in the Fed's policy rate. Nor was there any measurable increase in default risk. Risks on all these important fronts will likely remain low for the foreseeable future.
Investors now seem to agree, as seen in the substantial reversal of June's credit spread widening, with spreads since returning close to or below their narrowest levels of the year. For example, yields for the broad universe of high yield securities have moved to about 6%, following a brief, albeit unsettling, move to about 7% (source: BofA Merrill Lynch U.S. High Yield Index). How did the turnaround happen?
Where anxious individual investors were selling, institutional investors were buying – and then individuals followed. They may have remembered why they buy bonds in the first place: for stability, income and, in some cases, the chance at capital gains (absent default).
The stabilization of the bond market is owed in no small part to the Federal Reserve and Chairman Ben Bernanke, whose muddled message following the June 19 Federal Open Market Committee (FOMC) meeting was made clearer and more refined – and offered to a more receptive audience – particularly when he delivered his semiannual Monetary Policy Report to Congress on July 17. Bernanke's focus on the policy rate has been particularly important.
There are three important takeaways from the chairman's testimony that we believe have shelf life:
1) Tapering is not tightening.
It is widely believed that tapering of asset purchases will occur this coming September, but Bernanke reiterated the analogy that the Fed will merely be letting up on the accelerator rather than braking. The current consensus is for a reduction from $85 billion per month to $60 billion – $65 billion in September.
To provide some perspective, the experts at PIMCO's mortgage-backed securities (MBS) desk have pointed out that the expected $10 billion reduction in Agency MBS purchases – the other $10 billion – $15 billion will be from Treasuries – will be less than the reduction in MBS origination occurring as a result of the recent plunge in mortgage refinancing activity tied to the increase in mortgage rates. The net effect is that we expect the Fed will be purchasing, on a percentage basis, more Agency MBS than it did when the program began.
2) The policy rate, the policy rate, the policy rate!
Bernanke also made clear the distinction between its asset purchase program (aka QE3) and the federal funds rate. These are two separate tools that will not move in tandem. As the Fed has emphasized, there will be considerable time between the end of asset purchases and the first hike in the policy rate. PIMCO now expects the fed funds rate to remain unchanged until early 2016, given persistently low inflation and slow growth.
3) Data, rather than a date, will determine the Fed's next move.
When the asset purchases began in September 2012, unemployment was at 8.1%. Today, after nearly a full year of data and a 0.5% drop in the unemployment rate, the Fed has only now become motivated to consider tapering. In other words, it takes cumulative data to make a case for the Fed to decide on a change in policy. Ultimately, it's the data, and not simply the passage of time, that will influence the Fed's decision-making.
These messages are resonating in today's bond market, and they will remain in force for quite some time.