The Calm before the Storm
By Zach Berg, CFA
April 23, 2012
For all of the noise and unease surrounding financial markets last week, Treasury yields traded in a very narrow range, closing out Friday with yields only slightly lower across the curve. In fact, both 10-year and 30-year Treasury yields stayed within a 7bp envelope during the entire week. The story was much the same for the rest of fixed income where broad index spreads of corporates, agencies, and mortgage-backed bonds all finished the week either unchanged or 1bp wider, according to Yield Book figures. Spanish and Italian fears continued to weigh on risk sentiment, where 5-year credit default swap spreads of Italy closed at their highest levels since mid-January (463bp), while comparable Spanish CDS spreads set an all-time high on Monday (511bp). In Spain, “La Furia Roja” (The Red Fury) is a nickname for the pride of Spain, the national soccer team, and serves a very apropos moniker given the ferocity of the intensification in which Spanish sovereign yields have come under during the past 35 days. As the derivative market for protecting against a Spanish default was soaring last week, so to were nominal yields, where Spanish 10-year yields broke the 6% threshold on Monday. Yields later retreated ahead of and after the country’s 2-year and 10-year auctions on Thursday, as both reached the nation’s targeted sales levels. The reprieve was short-lived though, as those same yields rose from an intraday low of 5.7% on Wednesday to top 6% again on Friday, before closing the week at 5.9364%. Nonetheless, the tumultuous nature of the European markets and an unexpectedly greater increase in weekly initial jobless claims to their highest levels since early January, did not provoke much of a move in Treasuries. Consider that during the preceding five weeks, 10-year yields had moved on average 16bp on an intraweek basis, based on close of the day yield levels. Examining the Treasury market as a whole through the use of the Bank of America/Merrill Lynch MOVE Index, which is a normalized weighted average of the one-month implied volatilities of 2-year, 5-year, 10-year and 30-year Treasury options, displays a market that is at its lowest levels of volatility since mid-March. It appears that Treasuries are coiling ahead of this upcoming week’s FOMC meeting, which coincidently is exactly the same point in time that volatility was subdued and then erupted last month, leading to a 40bp sell off in 10-year yields.
This Wednesday’s FOMC rate decision will have the usual statement release (12:30pm), but will be followed by an update to the Fed’s Summary of Economic projections and a Bernanke Press Conference at 2:15pm. Expectations are for the statement to remain fairly unchanged with the chance for minor tweaks given the slowing of better than expected economic data over the past month. The Fed is expected to reiterate its pledge to maintain rates on hold until late-2014 and its verbiage towards reviewing its securities holdings based on economic conditions. The opportunity for volatility however, may originate from the updates to the economic projections. These projections are released quarterly and include the Fed’s estimates of changes in Real GDP, the Unemployment Rate, PCE Inflation, and Core PCE Inflation. The figures released display the central tendency, which are the Fed’s projections less the top three and bottom three, as well as the range of forecasts for the next three years and longer run estimates. In addition, the Fed releases each participants (no names) appropriate timing and pace of policy firming in the form of a graph. January’s forecast of these two figures is shown below.
NOTE: In the upper panel, the height of each bar denotes the number of FOMC participants who judge that, under appropriate monetary policy and in the absence of further shocks to the economy, the first increase in the target federal funds rate from its current range of 0 to ¼ percent will occur in the specified calendar year. In the lower panel, each shaded circle indicates the value (rounded to the nearest ¼ percent) of an individual participant’s judgment of the appropriate level of the target federal funds rate at the end of the specified calendar year or over the longer run.
A more hawkish stance in the form of higher rate forecast or a moving forward of the appropriate pace of tightening may lead to a re-pricing of Fed rate hikes, which would in turn pressure Treasury yields, especially 3-year and 5-year yields. An example would be if one of the members whom previously indicated a 2014 hiking, changes their forecast to late 2014. That type of re-pricing is exactly what occurred leading into and following March’s FOMC meeting, where Fed Fund futures moved forward the anticipation of the first rate hike to the second quarter of 2013. This led to 3-year yields experiencing the greatest proportional amount of yield change, as they traded off 36% higher in the manner of a week (50% over a two week period). Heading into Wednesday’s meeting, Fed Fund Futures are currently pricing for the first rate hike to occur roughly around mid-2014, leaving plenty of room for expectations to move forward.
The other potential source of instability for Treasuries could come from the Chairman’s press conference, where he will surely address the prospects of further quantitative easing. If Bernanke sticks to the recent Fed speak mantra of emphasizing that further asset purchases are predicated on the economy worsening, the long-end of the Treasury curve may be displeased. Bank of America/Merrill Lynch estimates that Treasuries are pricing in a 50% chance of further QE, which leaves the long-end susceptible to a sell-off if Bernanke fails to deliver. Over the past few months, a market that has become “punch-drunk” on Fed easing has greeted any sign of economic weakness with increased expectations and anticipation that further QE is incredibly close at hand, only to later be disappointed. With a considerable amount of the downside risks appearing to be priced into Treasuries, including the QE expectations, the depressed level of yields presents a backdrop in which the risk to a movement in rates may be skewed towards higher yields given the greater likelihood for the Fed to disappoint or sound hawkish as opposed to the other way around. Then again, as the trading activity displays entering this Monday morning there remains room for yields to move marginally lower with Europe apprehension remaining extremely high given potential shake-ups in the political landscape of core countries, as well as, fears of a deeper European contraction and a harder Chinese landing. Whichever way yields break, it appears the week ahead may be in store for some choppy trading waters with implied volatility low and plenty of key events to test last week’s calm seas.
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