the term exit strategy is usually reserved for private equity investments or military engagements not monetary policy but we have a feeling bond market investors will soon become very interested in the timing and execution of the Fed’s QE and ZIRP exit strategy. This Tuesday MN Fed’s Kocherlakota said in a speech “Conditions will warrant raising rates some time in 2013 or, possibly, late 2012” with the caveat of “If the outlook for inflation fell sufficiently and/or the outlook for unemployment rose sufficiently, then I would recommend adding accommodation”. Not exactly hawkish but it was a notable statement that we’ve not heard from a Fed official in a while.
The market seems content with the notion that ZIRP and likely thus QE will be in place until the pledged 2014 which by the way is when Bernanke’s term expires (although if Obama is reelected we see no reason why he won’t be reappointed). However we would be naive if we assumed the market would wait until the day they quit to begin pricing in the exit.
According to Bloomberg the Fed currently owns about $1.4t in USTs net of QE and Operation Twist and we are guessing the weighted maturity of their portfolio is in the 5-7YR range (last we checked). But this massive supply doesn’t tell the whole story. The UST debt binge over the past few years shows up in a heavily weighted wall of maturity out through 2014. If you include the amount of existing debt that must be issued to roll principal and interest of these bonds you would find $1.035t due in 2012, $1.446t in 2013 and $1.229t due in 2014 for a grand total of $3.71t that must be refinanced between now and year end 2014. Add that to the Fed’s holdings (doesn’t include $1.2t MBS) and you get over $5.1t in potential supply hitting the market over the next 2 years. To put that number in perspective, total debt held by the public at year end 2006 was $4.9t.
So over the next 2 years the treasury market will need to absorb supply that exceeds total outstanding just 5 years ago and at the lowest coupons in history which are currently negative. Because QE 2 and Operation Twist have absorbed so much of the supply over the past year (close to 100% of new issuance equivalent) we believe the market is currently operating under a false sense of security in the demand side of the treasury market. Absent the Fed where would interest rates be trading? To put a conservative number on you would at minimum expect a 5YR to return inflation around 2.5% and should really be closer to nominal GDP near 4.0%.
We aren’t suggesting the market won’t take down all this supply but with the Fed out of the way at what price is the bigger issue. It’s highly unlikely the free market would take down massive supply at negative coupons and we would expect a fairly large concession to begin building prior to supply coming to market. To compound matters the market is already very long fixed income. We have highlighted the massive fund flows into bond mutual funds and in addition due to bank deleveraging they have built up a sizable securities position. Since 10/08 bank assets in government securities has increased by 50% or $624.5b while over the same time bond funds have seen inflows of $785b (as a comp equity funds have seen outflows of $289b).
Presumably when the Fed exits the economy and equity market will both be on stronger footing and the treasury will have to compete for money that would otherwise be in loans on bank balance sheets and in equity mutual funds. This will require an even higher premium over current yields.
With Operation Twist ending in June and barring some economic collapse over the next couple of months the Fed should be on hold. We think last year’s Aug crash was a QE reflation correlation unwind in risk assets. This year post Operation Twist the market may well be looking to front run the Fed’s exit from ZIRP and with all the negative convexity built up in the bond market it could be just as violent but this time in the “risk-free” market instead.