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Ahead of Wall Street

Wednesday, May 29, 2013

Stocks wavered a bit last week as questions about the Fed’s bond purchases took center stage. But investors’ confidence seemed to have been restored by the long weekend, with the stock market making a fresh record close on Tuesday. Strong housing and consumer confidence data provided the reassurance that the economy had enough underlying momentum to push it along.

Stock market investors then started noticing the rising yields on treasury bonds, with the benchmark yield on the 10-year bond reaching its highest level in 13 months. This took the wind out of the Tuesday rally’s sails towards the end of the session and will likely remain a dominant theme in today’s trading session as well. But it need not be a big worry in the long run as the normalization of interest rates is a necessary precondition for putting the economic recovery on a stronger and more sustainable footing. That said, we are still far away from interest rate levels that can reasonably be considered 'normal'.

I have been in the camp that expects the Fed to start tampering its bond purchases in the not-too-distant future. In fact, I am of the opinion that the odds of the taper announcement coming at the June FOMC meeting will increase significantly if we get a strong non-farm payroll report next week. Given all of this, it makes perfect sense for treasury yields to move up. Rising yields could become a drag for the stock market in the short run, but they need not be a threat to the broader economic recovery.

We don’t know at this stage whether the bond market will start the yield normalization process with the taper announcement or this will be a slow and deliberate trend that will unfold over an extended period of time as the Fed’s balance sheet shrinks. And that is the key uncertainty.

The Fed may not have much control over the long end of the treasury yield curve in normal times. But given the size of the central bank’s balance sheet at present, these are hardly ‘normal’ times. What this means is that the Fed has enormous sway in the bond market and they simply wouldn’t let the yield curve ‘normalize’ in a disruptive way. And everybody knows that being on the wrong side of the Fed is guaranteed to be a losing trade.

Sheraz Mian
Director of Research

 

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