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Economic News & Analysis—February 5, 2014

Fed tapers, bonds rally

By James Kochan, Chief Fixed-Income Strategist

It was widely predicted that any reduction in the Fed’s asset-purchase program would send bond yields higher and bond prices lower. The Fed’s purchases of $45 billion of Treasuries and $40 billion of mortgage-backed securities have been credited with keeping bond yields low, so the gradual elimination of the asset-purchase program (tapering) was expected to reverse some of those gains. Instead, bond yields are lower now than when the Fed began tapering. The yield on the benchmark 10-year Treasury note was at 3.00% on December 31, just before the first round of tapering began. It is now at 2.65%.

Turmoil in emerging countries’ currencies has created a flight to safety among overseas investors

Because the Fed is so visible, it is easy to assume that it is the most important influence on market yields. Often, however, that is not true. Many times during the past five years, swings in foreign demand for Treasuries have had a greater impact on Treasury yields. These past two weeks provided another example. Turmoil in the markets for emerging countries’ currencies has created yet another flight to safety among overseas investors. While not on the scale of the European crises of 2010 and 2012, when Treasury yields dropped by more than 100 basis points (to record lows in 2012), this latest bout of market volatility has shaken confidence in emerging markets currencies and equities.

The U.S. equity market has not been immune from these developments. Whenever so-called risk-off trade takes hold among investors overseas, a similar—though less pervasive—psychology often emerges among domestic investors. Equities and junk bonds are usually the victims, and Treasuries are usually the beneficiaries. Since January 1, the S&P 500 Index has declined 100 points, and yields on junk bonds have increased 15 basis points in the past week.

These are not major moves, and they could easily be short-lived. Several central banks in the emerging markets countries have taken forceful action to steady their currencies. If they are successful, foreign investors might return to those markets and domestic demand for equities would be expected to improve. Treasury yields might then return to the late-December levels. The lesson, however, would still be that the Fed is only one of many buyers of Treasuries and, often, not the most influential buyer.

The pace of issuance of Treasuries has slowed sharply

Another reason why Fed tapering might not be pushing yields substantially higher is that the pace of issuance of Treasuries has slowed sharply. As recently as 2012, the federal deficit was around $1.3 trillion. Today, it is around $600 billion. More tax revenues as the economy recovers, combined with slower growth of federal spending, have reduced the deficit and, consequently, the amount of debt the Treasury must issue. Indeed, if the Fed had continued buying $45 billion Treasuries per month, its purchases would have almost equaled the Treasury’s net issuance of bills, notes, and bonds—a prospect that has made many Fed officials uncomfortable.

Other factors and market participants than the Fed can have a powerful impact on bond prices

Markets have a habit of confounding the majority. As 2014 began, equities were expected to continue to rally and bonds were expected to suffer as Fed purchases were scaled back. Instead, the equity markets have struggled, and Fed tapering has been a nonevent for bond prices. Once again, turmoil overseas has boosted demand for U.S. Treasuries, sending yields lower, even as the Fed announced another round of tapering. In theory, less Fed buying should send yields higher. In fact, the markets are demonstrating again that other factors and market participants can have a more powerful impact on bond prices than the Fed.

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