After years printing money, it seems that the press at the US FED are finally running out of ink with “Helicopter” Ben Bernanke announcing last week that the party will be over by mid 2014.
The seeming everlasting QE program will begin to be scaled back this year as the US central bank looks to try to start the long path to a normalisation of US monetary policy. The news created bump in the road for equity traders who drove the US markets down for the worst week this year. Gold has been hit dramatically and indeed sold down to a level that now makes several miners’ business unfeasible. But it was in the bond market where the fireworks were really felt as Treasuries took one of the worst weekly hits in memory with the yield on a 10Y Treasury Note rising 38 basis point last week – a rise whose magnitude has not been seen since 1994. Given the low yields, a rise of 38 bps corresponds to a 18% increase, something that puts the largest bond fund in the planet (from PIMCO) in a bit of trouble and so it becomes understandable that its boss Bill Gross is spitting blood of Bernanke’s policies.
Bill Gross PIMCO
It was only September last year that the FED announced its so called QE3 program, purchasing $85 billion of bonds each month. That unsurprisingly helped yields decrease right across the board and added a much needed filip to the US housing market as mortgage rates plummeted to historic lows. Inflation still isn’t picking up despite the dollar being debased by the central bank, but give the exceptionally low yields, real rates of return to bondholders , certainly sub 10 years, have actually been negative. So elevated were expectations about the FED continuing its bond purchases that investors were willing to hold an asset that was effectively stealing their wealth, as the negative yield obtained by buying TIPS shows. Many investors such as pension funds, endowments and other institutional investors in fact had no choice other than to invest in the low risk profile offered by Treasuries given their mandates but, with the FED U-turning on monetary policy, analysts now expect a rise in yields to over 3% by the end of this year. For existing investors in the bond funds this means capital losses but for future pensioners then this is welcome as annuity rates will rise back to near realistic levels.
The yield on 10Y Treasuries (constant maturity) closed out 2012 at 1.78%. By the end of January, the yield climbed to around 2% mostly due to the fiscal cliff issues. As negotiations between the Dems and Reps were finally resolved, albeit at the 11th hour, yields dropped to as low as 1.66%, in fact that level was seen just one month ago, in May.
With the fiscal cliff now behind out backs, the US economy improving, manufacturing data showing expansion again, and housing data finally adding to the party, Benny boy thought it was time to quietly leave the room and scale back on QE. He’s right on scaling back but not on the “quietly” part. The US economy has been on drugs. As soon as you try to withdraw those drugs, the patient will feel inevitably fee painful withdrawal symptoms even if in the long term they’ll be more healthy. However, the QE dependency tablet may not be able to be withdrawn from the patient just yet, as evidenced by the US GDP figure for the first quarter which was reported lower than first thought at 1.8%, a major blow for the economy but a remarkable hope for all QE4EVA dependents.
With all this in mind, and as we have stated in recent months, a drop in equities was needed as stock prices were out-of-sync with the real economy. If the drop extends further then we will become active buyers of selected Europe – Spain & Italy in particular and also China and possibly Japan (around 11800). For now, we prefer to continue to add, on downdrafts, to stocks in specific sectors such as the mining one. Certainly the drop in gold prices means trouble for many junior miners and AIM companies that were never profitable, but it will lead to some consolidation and opportunities for the stronger companies.
In terms of Treasuries, we believe that the FED won’t allow much more immediate appreciation in yields and will likely step up its rhetoric and back-pedalling seen in recent days regarding the “taper caper”. They have no choice frankly as it would just undermine government efforts to reduce debt through actually increasing debt service costs (with rising yields). Still, this is only delaying the inevitable and we think the bubble has certainly now burst in bonds as we suggested right at the beginning of the year in our magazine as a theme for 2013. It is likely that we are in the nascent stages of material rising yields but this will be jerky and volatile. Trade size appropriately!