While there has been the usual keen market focus on what the FOMC and some of its key members have been saying in the past few weeks, perhaps not enough attention has been paid to what the Fed has been doing.
T he Fed has been removing duration from the bond market at a steady pace. The Fed has added about $200 billion in 10-year equivalents to its balance sheet and will add another $200 billion more before Operation Twist comes to an end in June.
The main effect of the Fed’s maturity extension program has been to support the prices of risk assets through the portfolio channel effect. In doing so, Operation Twist has successfully repeated the rallies generated during QE1 and QE2.
In each of these previous QE episodes, the rally in risk assets was concentrated in the first half of the quantitative easing period and tended to fade away as the program approached an end. Operation Twist may have reached a similar turning point. The end of the program is in sight and there may indeed be some volatility associated with the end of Operation Twist, but we do not expect a major selloff in risk assets as occurred following the end of QE1 and QE2.
In both of these cases, a risk-off phase was ushered in by exogenous shocks unrelated to the Fed’s efforts, specifically, an escalation in financial systemic fears stemming from the European sovereign debt crisis.
It certainly complicates matters that this systemic risk refuses to dissipate completely: Spanish and Italian bond spreads have widened again in the past week as the government balked at imposing new austerity measures in the face of contracting economic growth.
Operation Twist and U.S. Financial Markets
Domestic U.S. financial spreads have followed Spanish spreads higher, but contagion to U.S. financial markets should be less intense than occurred last year in the event that European stress spikes again.
One reason is that the Fed’s recent stress tests showed that U.S. banks are so well capitalized that they could survive a very nasty economic and financial backdrop. Still, we do not wish to downplay the risks facing U.S. markets. Contagion is very difficult to predict. Moreover, the European Central Bank (ECB) may be slow to react if Spain goes into a tailspin.
Recent economic data confirm that Germany is expanding at a solid pace, while Spain, Italy, Portugal and Greece are mired in recession. With German unemployment at a 20-year low and several healthy wage settlements in the news, it is only a matter of time before the ECB is forced to grapple with the dilemma of policy rates that are too loose for the core and too tight elsewhere.
Nonetheless, our fixed income team still thinks that valuation is relatively attractive in most spread products, especially as one moves down in quality. While there may be a temporary disruption in risk assets with the end of Operation Twist and risks from European sovereign debt flare-ups, the end of previous QE episodes was marked by a sharp deterioration in leading economic indicators. So far this year, these indicators remain largely in an upward trend.
Bottom line: Watch for increased volatility in the bond market as the end of Operation Twist approaches. However, an overweight position is still warranted within U.S. fixed income portfolios.