June 26, 2013 | 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.
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.
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.
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