This note was originally published
at 8am on December 11, 2013 for Hedgeye subscribers.
“Time destroys the speculation of men, but it confirms nature.”
Marcus Tullius Cicero was a Roman philosopher, politician, lawyer, orator, political theorist, and constitutionalist (no word on whether he played hockey). His impact on the Latin language was so deep that the history of prose in both Latin and European languages, up until the 19th century, is said to be either a reaction against or a return to his style. To use a sports analogy: he was an impact player.
Like many of you, I tend to tune out much of the main stream media, but I did catch myself watching a little bit of CNBC yesterday. Interestingly, it actually made me realize that the buy side, sell side, and media are arguing with many of the same platitudes on the topic of tapering. In short, no one has conviction or a strong insight. Or certainly, unlike Cicero, their views are not having an impact.
In the land of bonds, of course, Bill Gross from PIMCO is widely considered to be the impact player. And rightfully so, as PIMCO manages over $2 trillion in assets and is the world’s largest bond investor. Even if we don’t agree with PIMCO’s research or views, there can be no debate that the firm has the ability to impact asset prices in a meaningful reallocation.
So, what is the latest from the big bond boys on the taper? Well, this is what Gross wrote in his most recent monthly letter (which is usually a fun read by the way!):
“The taper will lead to the elimination of QE at some point in 2014, but the 25 basis point policy rate will continue until 6.5% unemployment and 2.0% inflation at a minimum have been achieved. If so, front-end Treasury, corporate and mortgage positions should provide low but attractively defensive returns.
We have positioned our bond wars portfolio – heavily front-end maturity loaded along with credit, volatility and curve steepening positions, with the aim of outperforming Vanguard as well as many other active managers.”
In part, especially given PIMCO’s sizeable position, Gross’s job is to influence and ensure the bond market doesn’t shake, rattle, or roll in any direction that isn’t beneficial to PIMCO. If you are Gross, you certainly want the incremental buyer to be focused on mortgage backed securities.
Currently, $40 billion of the Fed’s monthly purchases are in the MBS market. In aggregate, this is more than half a trillion in annual purchases of mortgage backed securities. The impact of multiple rounds of QE has been that the premium of Agency MBS over Treasuries has narrowed by some ~50 basis points from pre-QE to post-QE.
Given that 34% of PIMCO’s Total Return Fund are in agency MBS, there is some serious interest rate risk in that position. By our estimation, a 50 basis point move in the spread of Agency MBS has the potential to lead to 5% downside in price. To the extent that 34% of PIMCO’s “book” has the potential to be marked down 5%, that is a big deal for PIMCO and the associated market.
Reflexively, if PIMCO were to underperform, they would then be forced to liquidate MBS positions as investors exited their funds. In turn, this would amplify any move in price. A mass exit of PIMCO would be an “Aye Carumba” moment in the MBS market to be sure.
Back to the Global Macro Grind…
On the longer end of the curve, specifically 10-year yields, tapering is getting somewhat priced in. In the Chart of the Day, we show this graphically by comparing 10-year yields, to the Fed Funds rate, to the Federal Reserve balance sheet. As the chart below shows, 10-year yields are now back at a level not seen since early 2011, which pre-dated QE Infinity (i.e. the open ended purchases that began in September 2012).
In the hypothetical world where 10-year rates actually get priced based on economic fundamentals, the current spread of 2.6% between the 10-year yield and the Fed’s discount rate may not be far off reality. For context, the average spread between the two over the last decade was about 1.7% and since 1954 0.54%. Certainly, the 100 basis points widening of this spread over the last year is indicative of some level of tapering being priced in.
This all leads to an interesting question: will tapering be a ‘sell the news’ moment for 10-year yields? That’s a question I’ll leave to the speculators and those that need to protect their book to answer...
One point that many pundits don’t seem to be talking about is that a decline in tapering will be positive for the U.S. dollar. This is further supported by a point we have been highlighting consistently, which is that the Federal deficit has been narrowing. In the fiscal year ending 2013, the federal deficit was below $1 trillion for the first time since 2008.
This improvement continued into this fiscal year as the deficit in October was -$91.6 billion, an improvement of 24% year-over-year. The Treasury will release November’s budget numbers at 2pm and we would expect similar improvement. In addition to this budget improvement, the fact that Congress seems to actually be functioning should also bode well for the U.S. dollar.
In fact, last night the House and Senate announced a two year budget deal. Even if the deal isn’t ideal, thankfully our elected officials are at least getting out of the way and signaling to the world that they can functionally manage the country. From a deficit perspective, there will be $63 billion in increased spending (sequester relief) over the next two years, but that shouldn’t impact the continued narrowing of federal budgets. It’s amazing what our elected officials can accomplish when they get out of the way.
Just imagine what would happen if the un-elected officials at the Fed got out of the way, the strong dollar American growth story would be fully in play!
Our immediate-term Risk Ranges are now:
UST 10yr Yield 2.75-2.82%
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research