Policy-Induced Volatility Continues

The recent bond market collapse is reminiscent of the Great Crash of 1994. Further pressure on the economy due to rising interest rates could cause the Fed to revisit its timetable for QE.

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June 26, 2013   |    By Scott Minerd

Global CIO Commentary by Scott Minerd

The severe dislocation in fixed income markets is the result of investors’ surprise over the faster-than-expected pace at which the Federal Reserve indicated it plans to taper and eventually end quantitative easing (QE). There are parallels between this event and the bond market crash of 1994 when then-U.S. Federal Reserve Chairman Alan Greenspan increased the federal funds rate by 25 basis points. In the subsequent bond-market rout – the worst since the Great Depression – investors immediately began re-pricing bonds to where they assumed rates would be at the end of the tightening cycle, rather than waiting for interest rates to incrementally move to their new levels. Long-term rates doubled over the next six months and liquidity significantly dried up in the bond market.

When looking closely at the latest projections by the Federal Reserve, their outlook on the unemployment rate by the end of the year suggests that they believe economic activity will accelerate as we head into the summer. I do not subscribe to this view, as we are already seeing pressure on housing and the broader economy from higher interest rates, and the recent spike in yields’ negative impact is likely to continue to show up in the economic data over the summer. Adding all this up, there remains a strong possibility that the Fed will shift the tone of its guidance from QE tapering back to QE expansion or extension before the end of 2013.

 

Liquidity Deterioration in the U.S. Corporate Bond Market

As a result of increased banking regulations, U.S. primary dealers’ positions of corporate securities, including commercial paper, investment grade, and high-yield corporate bonds, have declined substantially from the peak of $260 billion in 2007 to the current level of $68 billion. This reduction in bond inventories could prove to have a negative impact on market liquidity. Investors may have difficulty unwinding their positions amid rising interest rates, as dealers shrink their corporate bond holdings, pushing bond yields higher.

U.S. PRIMARY DEALER POSITIONS OF CORPORATE SECURITIES*

CUMULATIVE NYSE ADVANCE/DECLINE LINE AND THE DOW JONES INDUSTRIAL AVERAGE

Source: Federal Reserve Bank of New York, Bloomberg, SIFMA, Guggenheim Investments. *Note: Corporate securities include commercial paper, investment grade, and high-yield corporate bonds. Data for 2013 as of 1Q2013.

Economic Data Releases

GDP Revised Down Sharply, Housing Market Continues to Strengthen

European Confidence Up, Chinese Manufacturing Activity Worsens

Important Notices and Disclosures

This article is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. This article contains opinions of the author but not necessarily those of Guggenheim Partners or its subsidiaries. The author’s opinions are subject to change without notice. Forward looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC. ©2014, Guggenheim Partners. Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information.


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