MacroScope

The 1994 bond market massacre is remembered with horror by those who lived through it. Yields on 30-year Treasuries jumped some 200 basis points in the first nine months of the year, hammering investors and financial firms, not to mention thrusting Mexico into crisis and bankrupting Orange County.

The accepted story is that an over-eager Federal Reserve set off the carnage by raising interest rates too soon – the sort of premature move that current Fed Chairman Ben Bernanke has suggested, again and again, that he is not going to make.

But what if the conventional wisdom about 1994 is wrong? Steven Englander, Citigroup’s head of G10 currency strategy, says that when it comes to the Fed’s balancing act of a mandate – price stability and full employment – the Greenspan-led incarnation, in this instance at least, deserves top marks.

The Fed’s tightening cycle, which began with a modest 25-basis-point hike in February, pushed short-term interest rates up by 2.25 percent by the end of the year. Yes, Treasuries and the dollar took a beating. But by 1995, the Fed could point to a lower jobless rate (5.5 percent vs 6.5 percent in early 1994), falling inflation and slower compensation growth. And, of course, an economy and stock market that were about to take off.

In other words, 1994 was a great success, at least in terms of the dual mandate. To the FOMC, inflicting pain on over-leveraged bond investors may well have seemed an acceptable price to pay.

It’s that time again: Fed watchers are already parsing possible changes to the January policy statement, even before it is released. Goldman Sachs economists in particular have identified one passage ripe for some type of tweak — one that could signal the appetite for continued bond buys:

With Treasury purchases under the new regime already underway, the statement that Treasury purchases would ’initially’ occur at a pace of $45 billion per month will have to be adjusted. If ‘initially’ is replaced with another modifier such as ‘at the present time’ rather than deleted, it would suggest downside risks to the size of     the Treasury program later this year.

By almost all accounts, the Federal Reserve is expected to “stay the course” on its massive bond-buying program after next week’s policy-setting meeting. That would mean a continuation of the $85 billion/month in total purchases of longer-term securities, probably consisting of $40 billion in mortgage bonds and another $45 billion in Treasuries. Laurence Meyer of Macroeconomic Advisers is one of countless forecasters predicting this, calling it the “status quo.”

Problem is, the U.S. central bank’s current policy is not simply to buy $85 billion in bonds — and if it does announce such a program on Wednesday, it should probably be interpreted as policy easing, not a continuation of current policy.

The $45 billion in longer-term Treasuries is part of a program called Operation Twist that offsets those purchases with $45 billion in sales of shorter term Treasuries. In June, Fed policymakers extended Twist to the end of the year, meaning the market — which rallies each time the Fed eases policy — should have priced in an end to the $45 billion shuffle in the Fed’s portfolio of assets. It also means that there is really only $40 billion in outright bond-buying happening today, as part of the Fed’s third round of quantitative easing (QE3). Not $85 billion.

A slightly bigger than forecast 5.7 percent rise in sales of new homes in September reported by the National Association of Realtors on Wednesday lends credibility to September’s jump in housing starts, but appears neutral for Federal Reserve monetary policy discussions.

The jump in new home sales seems to have largely justified the 11 percent jump in September housing starts, says Decision Economics senior economist Pierre Ellis. The inventory of houses for sale at the end of September rose just 1.4 percent, from the end of August and the months’ supply fell to 4.5 months from 4.7 months, he added.

Thus, the increased production of houses seems not to have involved any “over-exuberant optimism” – and the impact if demand were suddenly to evaporate would be contained, he said. “Healthy skepticism seems to prevail in builderland,” Ellis observes.

Overseas investors have yet to sour towards U.S. assets despite high government debt levels, according the latest figures on capital flows.

Including short-dated assets such as bills, foreigners snapped up $107.7 billion in U.S. securities in February, following a downwardly revised $3.1 billion inflow for January. At the same time, the United States attracted a net long-term capital inflow of just $10.1 billion in February after drawing an upwardly revised $102.4 billion in the first month of 2012.

The data showed China boosted purchases of U.S. government debt for a second month in February, but also some waning of demand for longer-dated securities.

U.S. Treasuries have taken quite a battering this week, and there has been no shortage of explanations from market pundits. For some, the downturn reflects an improving economy and the pricing out of expectations for further monetary easing from the Federal Reserve. For others, the market is playing catch up after eyeing firmer inflation numbers and a better if still anemic employment backdrop.

The Fed’s statement this week lent itself to a hawkish interpretation since what few changes were made appeared positive. The bond market responded in kind, adding to a selloff that has seen ten-year note yields rise nearly 40 basis points in just over a week. George Goncalves at Nomura describes the price action:

U.S. Treasury yields had a seismic break and have finally moved this week, and boy did they move. The market blew through the range it had held for the past four months, our near-term targets and through several important technical levels, all in the space of two trading sessions.

Anemic economic growth in the United States has sparked fears the country was entering a Japan-style “lost decade.” The comparison also has implications for government bond markets. Some traders see the U.S. Treasury market’s new, lower-yielding structure as eerily reminiscent of trading patterns seen in JGBs (Japanese government bonds). Says George Goncalves at Nomura:

There has been much debate since the start of the ’08 credit crisis over whether the US is turning into Japan and if so how to trade it. We have spent a fair deal of time over the last two years developing a framework for how US rates investors can leverage these insights to “Trading USTs like JGBs.” […] One thing is clear: momentum trading starts to wane and narrower ranges will become the norm in a low yielding world with the Fed on perma hold meanwhile a lack of alternative fixed income products is still forcing investors to buy USTs.

This does not mean that investors can remain permanently bullish on Treasuries, however, Goncalves warns.

The U.S. Treasury bond market may be in for a bit of a rollercoaster ride over the near term as each new day seems to bring another deluge of debt, with the government trying to clear out all it can before the holidays. The Treasury on Wednesday sold $13 billion of reopened 30-year bonds, and investors dove in to scoop up the debt even though yields are hovering near record lows. Wednesday’s sale was the third of seven debt sales over an eight-session period, in which the Treasury is expected to move a total of $177 billion of paper. The rush of paper could give Treasuries a shaking.

Priya Misra and Marcus Huie, strategists at Bank of America Merrill Lynch, said in a research note:

The next week could see some choppy price action in the Treasury market. And not just because of concerns about Europe. Treasury investors have to absorb a very heavy supply calendar over the next week. Normally supply across the curve is spread out over a month, but the Treasury moved up its end-of-month auctions to avoid auctioning in the holiday week. We believe that short positioning of investment funds and foreign demand should help absorb the supply, but the market will likely attempt to set up before each auction. This should result in greater intra-day volatility in Treasuries.

Reporting for this post was done by the U.S. markets team in New York.

A number of Wall Street analysts have reacted to the historic downgrade of the U.S. AAA rating on Friday evening with a shrug. Some argue the ratings firm’s warnings about the U.S. debt deal offered an early signal, while others dismissed the action, questioning the company’s record of giving AAA ratings to housing assets that turned out to be toxic.

Vassili Serbriakov, currency strategist at Wells Fargo in New York, said:

It’s not entirely unexpected. I believe it has already been partly priced into the dollar. We expect some further pressure on the U.S. dollar, but a sharp sell-off is in our view unlikely.

Paul Dales, chief U.S. economist at Capital Economics in Toronto:

I don’t think it will mean too much to be honest. There will probably be an initial market wobble — FX markets might struggle and Treasury yields might fall a bit. The bigger picture is really that the world is not much different.

A potential downgrade of U.S. Treasury debt by a credit ratings agency, once seen as impossible for the world’s largest economy, could resound in financial markets more with a whimper than a bang. That’s because, as was evident in a Reuters poll, investors have largely come to expect it.

That Standard & Poor’s ratings agency will cut the U.S. debt rating from AAA to AA+ is “the market’s base case at the moment,” said Krishna Memani, fixed-income director at OppenheimerFunds, with $188 billion in assets under management.

The market does not expect a significant, long-term deficit reduction plan that would keep S&P from cutting the U.S. debt rating.