on Monday we addressed the Stock v Flow debate and posited that while the Fed believes its the stock that matters, what really matters is what the market believes.
Ultimately it doesn’t matter what the Fed believes but what the market believes. And if the Fed thinks we can get through the maturity wall of supply that is coming down the pike without some concession by the market when coupons are negative they could be in for a rude awakening. Anything can happen but we think the jury is still out and if stocks don’t crater this summer like last year it will be interesting to see who steps in to buy all this supply at negative yields.
At yesterday’s Fed press conference Bernanke gave us further assurance that the Fed believes when Operation Twist ends in June interest rates would not be affected because the stock of Treasuries on the Fed’s balance sheet would remain the same even though they were exiting the market.
There’s been some concern in markets about what will happen to bond yields at the expiration of Operation Twist on June 30th and some speculation on what the Fed might do–might need to do to keep downward pressure on yields. Is that a concern that you share and even your colleagues feel the need not to disappoint these kinds of market expectations?
Bernanke (emphasis ours) :
There’s some disagreement, I think, about exactly how balance sheet actions by the Federal Reserve affect Treasury yields and other asset prices. The view that we have generally taken at the Fed in which I think–for which I think the evidence is pretty good is that it’s the quantity of securities held by the Fed at a given time, rather than the new purchases, the flow of new purchases, which is the primary determinant of interest rates. And if that is–if that theory is correct, then at such time that our purchases come to an end, there should be relatively minimal effects on interest rates at that time.
Today Bill Gross was interviewed on Bloomberg to let us know his view which differs from Bernanke and seems to agree more with what we said on Monday (starting at about 8:20):
the Fed says this is a stock type of argument… I don’t necessarily take that view, I take a flow view that basically says hey, at 1.95% not much of a value there, so let’s see if the Fed doesn’t buy them let’s see who else will and so you know it will be an interesting experiment at the end of June if the Fed doesn’t do QE but for the moment I think the 10YR stays about where it is.
That almost sounds like a dare and is very similar to the point we made. Gross was betting on QE 3 and now we might infer from his comments that it was because he takes the flow view and that at the end of Operation Twist the Fed will be forced to come back in to support the market. However if they don’t extend the buying program the market will need to fill a big demand void therefore we might now infer that Gross is turning seller. Who will step up to the plate? The Fed v market tete a tete is about to get very interesting. We obviously agree with Gross and think the market will win. As we have stated before, Risk in Risk-Free is rising:
Between QE 2 and Operation Twist, the Fed has gobbled up close to 100% of net new issuance. It would be naive to think that at a removal of the single largest source of demand in the bond market would not have an impact regardless of the size of the balance sheet. Without the Fed propping up the market and with virtually the entire curve sporting negative coupons we see little incentive for bond investors to step in and take up the slack.
Sell in May and go away might be applying to the bond market, not the stock market…