Bond Market Weekly

This week was a big one for Fedspeak and speculation on the timing of the turnaround in monetary policy. A move to just an accommodative level of interest rates from the current environment where 0% interest rates has been and continues to be the breathing machine keeping the economy barely alive, will be a significant movement. And even though more people seem to be jumping into the “sooner rather than later” boat, a real turnaround in rates doesn’t appear to be much of a near term reality.

Fedspeak

San Francisco Fed President Janet Yellen used her appearance on Tuesday as an opportunity to comment on news of the Fed testing reverse repos with firms other than primary dealers. Reverse repos are used by the Fed to tighten money policy. Bernanke & Co. have spent most of 2009 buying everything in sight and leaving the market flush with cash and entering into reverse repos would lend out those same securities in exchange for cash. It’s not much different than just selling the securities for cash, but repos can be done on terms as short as overnight.

First of all, the fact that the Fed is looking beyond the 18 firms it is already set up to trade with is somewhat notable. The Fed wants the program to stay as liquid as possible, and expanding the number of firms the Fed trades with definitely achieves that goal, but the market may have started to get ahead of itself. The short end of the curve didn’t really react to the release, thanks to Janet Yellen’s speech, but street chatter was heavy as the market continues to gain more insight into how the Fed will unwind its balance sheet.

Excerpt from Yellen’s comments Tuesday:

“We don’t want anyone to question the bank’s ability and willingness to tighten monetary conditions when the time comes… Not now… We want to be absolutely certain that this is something we can do.”

Yellen is a voting member and her comments coincide with most of the voting membership of the FOMC, but views from outside the voting membership differ considerably.

Philadelphia Fed President Charles Plosser, who won’t get a FOMC vote until 2011, spoke on the same day as Yellen, but expressed a different stance. Plosser’s comments focused on the large lean toward riskier assets on the Fed’s balance sheet, including TALF and even the $1.25 trillion in agency MBS that the Fed will finish purchasing net week.

Excerpt from Plosser’s comments:

“My fear is that we are going to do things during the transition that never allow us to get out to a successful point at the end of the day… It’s more difficult this time because of the composition of our balance sheet.”

This begins to make me wonder. What kind of impact is the composition of the voting membership having on its policy? Do they have some information that non-voting members don’t have, or is Plosser just making outrageous comments from outside? Such a fragmented committee adds to the complexity of the Fed’s policy turnaround, whenever the decision is made.

Differing Views

A new perspective surfaced this morning in a Financial Times article saying that some FOMC members are considering removing the “extended period of time” wording that we have all gotten so used to seeing since March. This contradicts Fed comments from earlier this week. Gauging by what the market did this morning after the FT article surfaced, more credence is being given to speculation on what the Fed might do the language of the meeting statements than actual comments from voting members of the committee. The 2-year moved above 1% for the first time since September and closed there for the first time since August 28.

In my view this is the just the Fed testing the waters a little bit. The Fed Funds Target Rate is still being defined by a range (0-.25%) so the rate as it trades right now, (.12%) could still double and remain within the target range. So if you factor in the time it will take the Fed to end the buying programs, which is next week for Treasuries and most likely Q1 2010 for MBS, the gradual movement of statement language toward that of a Fed looking to begin tightening monetary policy and the need for at least a partial move in the market rate for Fed Funds, we are looking at a late 2010 rate hike at the earliest.
Cliff J. Reynolds Jr., Investment Analyst