Fed-speak: Ease Air Out of Bonds – Support Equities

By May 20, 2013, 9:51 AM Author's Blog  

While the fundamentals of our underlying economy bump along with continued structural headwinds and fiscal support from Uncle Sam remaining anemic, the Federal Reserve’s QE-infinity remains the underlying cornerstone supporting our markets.

With equities making new highs and high yield bonds trading at stratospheric levels, recent pronouncements from Fed officials strike me as looking to accomplish two goals:

  1. ease the air out of the bond bubble, especially the most speculative sectors of the market, i.e. high yield corporate bonds, while simultaneously,
  2. maintaining a base of support to the equity market.

While selected Fed governors have long called for an end to the QE “maddening manipulation of markets”, I strongly believe Fed chair Bernanke will be slow to ease his foot off that pedal and if he were to do so I think he would indicate he is not looking to apply the brakes but perhaps merely slow the rate of acceleration.

But let’s posture if the Fed were to actually not only decelerate but actually apply the brakes to its QE. What would be the normalized rate on the 10 year Treasury in an environment in which the “quoted” rate of inflation is running at 1.5%? Even if the 10 year were perceived to be “fully valued”, I believe the 10 year would be trading at best at a rate of 3% rather than the current rate of 1.93%.

A 100+ basis point selloff in bonds would be painful to those who own these instruments but given that markets tend to overshoot, the market decline would not likely be orderly. For that reason, I do not believe the Fed is likely to make any sort of of pronouncement of an actual end to QE. I think Bernanke and his likely dovish successor Janet Yellen will try to “talk” the market through this so as to try to ease the air out of what they know is a bond bubble.

On the flip side of the coin, that being the equity market, I see similar signals by the Fed to “talk” the market up and legitimize the current levels. How so? Bernanke just the other day delivered a commencement address promoting the benefits of innovation at Bard College. Specifically he stated,

. . . that IT and biotechnology have tremendous scope to improve healthcare – which absorbs a considerable amount of U.S. household income and where costs are projected to rise – as well as the potential for the development of cleaner energy.

One might wonder if a White House official helped him with his remarks?

All this said, what is going on in the real global economy? A continued sluggishness reflected by a decline in the price of most commodities. Even in the face of global liquidity printing provided by the Fed, ECB, and now the Bank of Japan, a basket of commodities reflected by the UBS Commodity Index is down over 20% in the last two years. What does that tell us? The underlying global economy continues to struggle with deflationary pressures. What else does it tell us and what do many in the markets share with me? Many market segments remain heavily manipulated by central banks and those doing their bidding for them.

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