LONDON (Reuters) - Markets tend not to fight the Fed because the Fed usually wins - but even the slightest ambiguity in the U.S. central bank’s intentions can lead to unseemly jostling.
Even though the Federal Reserve has never explicitly planned a policy of capping long-term government borrowing rates - nor even quietly acted to that effect - investors have behaved for months as if that’s what it is, or will, be doing.
Until this week it seems.
Ahead of another $110 billion deluge of debt sales from the U.S. Treasury this week, long-dormant bond yields spiked higher. The 30-year yield hit its highest since June and the yield curve between five and 30 years moved to its steepest since November 2016 - curiously the month of the last presidential election.
Mountainous new debt sales aside, President Donald Trump’s infection with COVID-19 and subsequent recovery was widely seen increasing the chances of a fresh fiscal support package for the economy this side of next month’s election - while also widening the odds on him winning the vote.
So markets, quick to price in a possible imminent wave of government spending - and likely even more stimulus in the first six months of a Democrat-led White House and Congress - have simply lifted the cost of new long-term debt on the assumption there will be a post-pandemic reflation of the economy.
Indeed some investors, such as Eurizon SLJ Capital’s Stephen Jen, thinks more Fed-supported government stimulus over the next nine months is likely “regardless of who the president will be”.
The yield spike then seems perfectly natural - until you factor in widespread assumptions about the Fed’s bond buying.
Although the Fed baulked this summer at formally capping Treasury yields via a policy of “Yield Curve Control” - a policy adopted in 1942 as government debt rose rapidly during World War Two and ran for nine years - investors have generally assumed the central bank will once again sit on any big rise in yields for years to come.
Or at least for maturities out to 10 years.
That assumption has seen most Treasuries almost flatline since March, with implied volatility in the bond market sliding over recent months to hit record lows just last week. .MOVE.
Underlining the prevailing view, asset manager Robeco’s latest report said it expected central banks to “focus on their new role as facilitators of the fiscal experiment - keeping nominal rates close to the effective lower bound and monetising fiscal deficits”.
And it expects 10-year Treasury yields to be capped at 1.5% for the next five years.
NOT SO FAST
But the problem right now for investors, traders and the Fed alike is how the central bank manages the process if it’s not explicit about a target. In other words, how much uncertainty remains within a loose yield-capping regime, and how will markets adjust to account for it?
The Fed’s landmark strategic shift to an “average inflation target” and “maximum employment” goal was a clear signal it wanted to keep rates lower for longer while tolerating periods of above-target inflation.
But it said little or nothing about tactics nor how it would manage the yield curve in the absence of policy rate moves.
Even though a cap of 1.5% would be an impressively low lid on rates, it’s twice where 10-year yields are now. And what happens with longer duration 30-year bonds which are highly price-sensitive to shifts in rates? Are long-bond yields allowed to skyrocket if reflation takes hold?
Research by CrossBorder Capital this week reckoned the Fed had achieved Yield Curve Control this year by stealth - or the threat of purchase, in effect, as there was no evidence it had bought any specific maturities with yield caps in mind.
But it said the Fed knows the market beyond five years is dominated more by supply and demand than rate expectations per se and - unlike at the time of the Fed’s World War Two experiment - the Treasury market is now about 40% foreign owned.
As to why the market has been so-well behaved until now, CrossBorder said the record low in implied bond volatility masks a surge in their measure of actual, or realised volatility, and the gap between the two is the widest in 30 years of data.
The culprit, it reckoned, was likely “short gamma” strategies which involve selling or writing both put and call options on Treasuries to benefit from a Fed policy suppressing implied volatility for years to come.
That, in turn, may help explain the record short speculative position that has built up in long-term Treasury bond futures in recent weeks - if those positions are designed to hedge the “short volatility” strategy.
Either way, the problem with these strategies, as seen in the equity market early in 2018, is that they can unwind violently as highly leveraged betting is covered.
Nuts and bolts perhaps, but dangerous nuts and bolts. The risk to prevailing assumptions and positions may be large if the Fed continues to leave yield capping vague.
by Mike Dolan, Twitter: @reutersMikeD; Editing by David Clarke
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