Reading the Tea Leaves
by Annaly Capital Management
Today’s “must read” comes courtesy of Professor Jeremy Siegel of Wharton Business School and “Stocks For the Long Run” fame. His Wall Street Journal op-ed, titled “The Fed’s Policy Is Working,” can be read online with a subscription. The piece can be summarized in the following quote:
“The recent surge in long-term Treasury yields has led many to say that the Fed’s second round of quantitative easing is a failure. The critics predict that QE2 may end up hurting rather than helping the economic recovery, as higher rates nip in the bud any rebound in the housing market and dampen capital spending. But the rise in long-term Treasury rates does not signal that the Fed’s policy has backfired. It is a sign that the Fed’s policy is succeeding.”
There is a phrase that goes something like "the stock market has predicted 9 out of the last 3 recessions.” The bond market is guilty of the same thing, predicting at least 2 out of the last 0 recoveries. Now that the gospel of efficient markets is taught in business schools far and wide, not just Wharton, there can be a tendency to think that every move in the markets is predicting the future. Isn’t that why stock prices have a heavier weighting than, say, manufacturers’ new orders in the Conference Board’s index of leading economic indicators?
Markets aren’t fortune tellers. Markets measure expectations of the future, and those expectations change as the available information changes. Siegel could have written today’s op-ed on two other occasions in recent years, which I’ve labeled for readers in the chart below.
#1: March-June 2008: The bond market had hope that Fed actions were working. The FOMC had already cut rates 300bps (and would actually go on hold until September 2008) and had been active in changing the structure (though not the size) of their balance sheet, creating the various lending programs like Term Auction Credit, etc. The yield on the 5 year rose around 150bps.
#2: December 2008-June 2009: The bond market had hope that Fed actions were working. In the aftermath of the Lehman/Merrill/AIGturmoil, the Fed had cut rates to 0% and tripled the size of their balance sheet. The yield on the 5 year rose around 160bps.
#3: October 2010-December 2010: The bond market has hope that Fed actions are working. Bernanke announces and implements another round of balance sheet expansion, and Obama announces a tax compromise deal. The yield on the 5 year has risen nearly 100bps.
Siegel also says that QE2 has sparked higher inflation expectations. The current level of inflation expectations, as measured by the breakeven inflation rate using the 5 year Treasury and 5 year TIPS, is 1.61%.
#1: March-June 2008: The rise in yields was met with a rise in inflation expectations from 2% to near 2.7%.
#2: December 2008–June 2009: The rise in yields was accompanied by a change from expectations of deflation (roughly -0.8% at one point) to inflation of 1.8%.
#3: October 2010-December 2010: The recent near-doubling of the 5yr yield has been accompanied by an increase in inflation expectations of only about 15bps, from 1.46% to 1.61%.
We aren’t making any predictions here, only observing that it might be premature to say QE2 “is succeeding.”