The coiled spring of a massive bear market in US government bonds is slowly being released, the implications of which risk derailing the economic upswing that has gathered pace over the past year or so.
US 10-year government bond yields are 2.92 per cent this morning, just a few ticks from a multi-year high of 3.00 per cent. Last year, 10-year yields traded at 1.45 per cent as the US Federal Reserve stepped up its quantitative easing and bond purchasing program.
The interesting aspect of the current bear market is that the Fed is still buying bonds at a rate of $US85 billion a month. This implies that the more than doubling of yields has occurred at the mere prospect of QE being scaled back and of course, on increasing evidence that the economic expansion is gaining self-perpetuating momentum.
The market is still speculating, quite rightly, that the US Federal Reserve will possibly start scaling back QE next week when the Federal Open Markets Committee meets.
The bond market matters, not just for the reason of funding the ongoing budget deficit which, according to the latest estimates from the US administration, will still be evident well into the 2020s, but also to cover the refinancing of maturing debt.
The government bond market is the risk-free financial market benchmark from which corporate bonds are priced. For many corporate borrowers, this means that higher government bond yields will mean rising borrowing costs. In the US, mortgage interest rates are also priced at a margin over government bond yields, usually the 30-year yield, so mortgage interest rates are also on the rise.
The increase in government bond yields in recent months equates to a tightening in monetary policy for the private sector and is therefore a dampening influence on the growth outlook. This is why some economists and the markets are antsy about the prospect of yet higher yields as the Fed steps away from its unprecedented intervention in the bond market.
In other words, the question is whether the economy can remain on track for 3 per cent GDP growth, with the unemployment rate heading below 6.5 per cent, if bond yields move much higher?
This is the critical issue for Fed policy and chairman Ben Bernanke and his fellow policy makers are fully aware of the risks from tightening policy too soon or by too much.
To square the circle, it is also why the Fed tapering or scaling back of the bond purchasing program will be modest, careful and adjusted according to market reaction. It will start small – perhaps reducing the bond purchasing program from $US85 billion a month to $US70 billion or so a month so the Fed can see how this change impacts sentiment. If markets recoil, the Fed will tread carefully; if they remain calm, the profile for tapering QE towards zero will remain.
It is interesting that despite the sharp rise in bond yields, share prices remain robust. US stocks were again higher overnight and closed just a couple of points from fresh record highs. The US dollar is also trading in a very orderly fashion and in broad terms, it has been in a tight trading range for many months.
If financial market players were worried about the tapering of QE being too soon and fearing too much, both US stocks and the US dollar would be hit hard. They are not.
This all suggests that next week’s meeting of the FOMC could be the start of something big. Having set policy successfully to avoid a rerun of the horrors of the 1930 great depression – recall that the unemployment rate peaked at 10 per cent in the current cycle versus 25 per cent in the 1930s – the Fed is about to embark on what will be a very long journey to normalise policy settings.
The end game for the Fed will be to not only end all bond purchases, but to slowly wind down its massively inflated balance sheet, which includes trillions of bonds purchased over the last four or five years.
The first leg of this process could occur within a year – that is, the Fed will have stopped buying bonds in the market. The next part of scaling back the balance sheet could well take decades. As Bernanke has noted, it may well be optimal to have the Fed simply let its bonds mature rather than going to the market to sell them.
This seems sensible but that will be a question for late 2014 and beyond.