FXstreet.com (Barcelona) - John Higgins, Senior Markets
Economist at Capital Economics notes that bondholders have not lost
faith in the Fed's commitment to low and stable inflation, but he
believes that that does not necessarily translate into healthy
returns.
He begins by noting that the Fed's commitment to price stability as
called into question two months ago when the wording of the FOMC's
statement of the 13th September was interpreted by some as a sign
that policymakers are willing to sacrifice inflation on the alter
of growth. In the week of the meeting, the breakeven inflation rate
on 10 year US T's rose by almost 30bps to a 17month high of more
than 2.6%.
However, Higgins highlights that while the fed may be willing to
tolerate higher temporary inflation, the idea that it is willing to
abandon price stability altogether and jeopardise three decade of
hard fought, inflation fighting credibility is fanciful. After a
careful reading of the FOMC statement it was clear that the pursuit
of open ended QE until there was a substantial improvement in the
labour market was conditional on the improvement being achieved
within "a context of price stability." Similarly, the Committee's
expectation that a highly accomodative stance of monetary policy
would probably remain appropriate for a considerable time after the
economic recovery had strengthened was also "to support continued
progress toward maximum employment and price stability."
He comments that such a reality check may partly explain why break
even inflation rates have been subdued, although he believes that
this is probability due to the fall in commodity prices and the
strengthening of the dollar since the launch of QE3. He notes that
the 5yr yield slipped below 2% this week for the first time since
September and despite the FOMC October minutes released yesterday
which hinted that the Fed would supplement its Maturity Extension
Programme when Operation Twist expires at the end of the year.
Higgins notes that even if the Fed is just as willing to keep
inflation low and stable today as it was before, bond holders will
have little cause for comfort if the central bank achieves its
objective. He writes, "The simple reason is that the 10-year US
Treasury yield is already lower than the Fed's (PCE-based)
inflation target of 2% and is unlikely to fall much further. On the
contrary, it is likely to rise substantially once the central bank
eventually begins to raise rates - perhaps to 4% once the economy
has made a full recovery and the Fed is pursuing a "neutral"
monetary policy."
However, based on seven major monetary policy tightening cycles
since the early 1970s, the 10 year Treasury yield has not tended to
rise in earnest until seven months or so before the Fed has begun
to raise rates which the central abnk itself has suggested is
unlikely before mid 2015. Higgins states that he expects the crisis
in Europe to result in a break up of monetary union beginning next
year, which should trigger renewed demand for US Government bonds
as a refuge from the turmoil.
He finishes by stating, "For these two reasons, (
I
) anticipate that the 10-year Treasury yield will remain around
1.5% until the end of 2014. Yet provided inflation is higher than
this level, the real return will be negative. And if the yield
starts to climb thereafter, things will only get worse for
bondholders."