Options Showing Quantitative Easing Working Before It Begins
Federal Reserve Chairman Ben S. Bernanke’s $600 billion plan to spark inflation in the U.S. economy is already showing signs of succeeding, if the market for bond options is any indication.
As the central bank starts a second round of purchases of Treasuries through its so-called quantitative-easing policy, investors are paying eight times more than in April for options on interest-rate swaps that protect against rising yields relative to those that bet on them falling, according to Barclays Plc data. Bonds that compensate for higher consumer prices also show heightened inflation expectations.
While a quarterly Bloomberg Global Poll last week of 1,030 investors, analysts and traders who are Bloomberg subscribers showed that 56 percent said the plan won’t boost growth, half said it will help avoid deflation. That may be more important to Bernanke because a general decline in prices makes consumers and businesses less willing to invest.
Policy makers, who have kept the central bank’s target for overnight interest rates between banks near zero since 2008, “are happy to see that inflation expectations have moved up” in the bond market, said Stuart Spodek, a managing director at New York-based BlackRock Inc., the world’s biggest money manager, with $3.45 trillion in assets. “There would be a lot more concern out there if the Fed was doing this and the market was telling you that we are still going to have deflation.”
Foreign officials are less complimentary, saying Bernanke’s strategy to inject cash into the economy by purchasing bonds will only succeed in devaluing the dollar and disrupting emerging-market economies as their currencies rise.
German Finance Minister Wolfgang Schaeuble said on Nov. 5 in Berlin that the Fed’s move was “clueless.” Brazil’s central bank president, Henrique Meirelles, said “excess liquidity” in the U.S. economy is creating “risks for everyone.” In China, Vice Foreign Minister Cui Tiankai said “many countries are worried about the impact of the policy on their economies.”
Even some U.S. government officials have been critical, with Senator Richard Shelby, the Senate Banking Committee’s top- ranking Republican, saying he’s “worried about the risks” of the Fed’s actions.
A total of 75 percent surveyed in the Bloomberg poll said the securities purchases will have little or no effect on joblessness, which has held above 9 percent since May 2009.
Bond yields show investors already anticipate faster growth. Yields on 10-year Treasuries, a benchmark for everything from corporate bonds to mortgage rates rose last week by the most since December, surging 26 basis points, or 0.26 percentage point, to 2.79 percent. The price of the benchmark 2.625 percent note due November 2020 auctioned by the government last week closed at 98 19/32 on Nov. 12. The yield rose five basis points to 2.84 percent at 1:47 p.m. in New York.
The difference between volatility on one-year options that lock in paying fixed rates on 10-year interest-rate swaps and those that grant the right to receive fixed payments, known as the payer skew, suggest traders expect higher yields. It’s up to 26 basis points from about 3 in April, according to Barclays.
“There has been a change in investors’ perceptions about inflation,” said Piyush Goyal, a fixed-income strategist in New York at Barclays. “The payer skew has risen by a massive amount.”
A committee of bond dealers and investors which meets with the Treasury quarterly noted the skew’s rise in November 2009 as a signal of investors’ concerns over record debt sales.
After the measure surged to an all-time high of 38 basis points in October 2009, the 10-year Treasury yield rose more than a percentage point to this year’s peak of about 4 percent in April. The skew then plunged to about 3 basis points by late April, just as the 10-year yield began a slide to this year’s low of 2.33 percent on Oct. 8.
While the skew is now rising, there’s little evidence of accelerating inflation. In two days the government may say that the cost of goods and services excluding food and energy rose 0.7 percent in October from a year earlier, according to the median estimate of 35 economists surveyed by Bloomberg. That would be the smallest year-over-year gain since 1961.
The Fed’s desire to spark some inflation is why it’s “pegging the 10-year note at about 2.5 percent and the federal funds rate at about zero for as far as the eyes can see,” said Jeffrey Gundlach, founder and head of Los Angeles-based DoubleLine Capital LP, which has $6.8 billion in assets. “The 10-year yield is being pegged at a lower level than would be the case if the Fed wasn’t buying bonds through quantitative easing.”
Gundlach, the only bond manager to post higher returns than Pacific Investment Management Co.’s Bill Gross in the past 5, 10 and 15 years, expects 10-year yields to remain at about current levels as the Fed buys more debt. Gundlach’s new fund, the DoubleLine Total Return Bond Fund, has gained 17.4 percent from its inception in April, compared with 8.5 percent for Gross’s Total Return Fund, Bloomberg data show.
The Fed said Nov. 3 that it would buy $600 billion of Treasuries through June because “the pace of recovery in output and employment continues to be slow.” It kicked off the program on Nov. 12 by purchasing $7.229 billion of Treasuries maturing from November 2014 to April 2016. Policy makers acquired $7.923 billion in Treasuries today.
“Bernanke will be successful,” said Fabrizio Fiorini, who manages about $8 billion in assets as head of fixed income at Aletti Gestielle SGR SpA in Milan. “A rise in yields, perceived as proof of the Fed’s success, will create a virtuous circle that will be helpful for the housing market, consumer confidence and consumption and probably employment.”
Letter to Fed
A group including former Republican government officials and economists urged Fed Chairman Bernanke to halt his expansion of monetary stimulus, saying it risks an inflation surge.
“The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment,” said the letter, signed by 23 people including Cliff Asness, who runs AQR Capital Management LLC, one of the world’s biggest hedge funds; Stanford University Professor John Taylor, creator of a monetary-policy formula used by the Fed; and Douglas Holtz-Eakin, a former Congressional Budget Office director.
The market for bonds that protect against rising consumer prices is signaling the same. The difference between yields on 10-year TIPS and Treasuries -- which represents the annual inflation rate investors anticipate over the life of the securities -- rose as high as 2.15 percentage points last week, from this year’s low of 1.51 points in August. The difference, known as the breakeven rate, averaged 2.11 points over the last five years.
The five-year, five-year forward rate the Fed uses to chart investor expectations for inflation surged to 3.08 percent on Nov. 1 from an almost two-year low of 2.17 percent on Aug. 24. The rate averaged 2.6 percent the five years before the beginning of the worst financial crisis since the Great Depression.
While Treasuries have returned 7.8 percent this year, including reinvested interest, they lost 3.72 percent in 2009 even as the Fed began purchasing $1.7 trillion of Treasuries and mortgage-related debt in its first quantitative-easing program, according to Bank of America Merrill Lynch index data.
Last week’s drop in Treasuries contributed to a loss of 1.4 percent since 10-year yields fell to this year’s low on Oct. 8, as measured by the firm’s Treasury Master Index. The longest- dated bonds, which are hurt the most when inflation accelerates, have tumbled 8.2 percent.
World equity and commodity markets have surged since Bernanke first indicated in an Aug. 27 speech to central bankers in Jackson Hole, Wyoming, that he was prepared to pump more cash into the economy.
The MSCI World Index touched a two-year high this month, and the Standard & Poor’s 500 Index reached its strongest level since September 2008. Oil climbed to a two-year peak, while gold and cotton rose to records last week, boosted by a weakening dollar.
Signs are emerging that the economy may be strengthening. Employers added 151,000 workers to payrolls in October, the first gain in five months, the government said Nov. 5. The Institute for Supply Management’s factory index expanded at the fastest pace in five months in October and its services index showed the quickest rate of expansion in three months.
“The economy has definitely done better since Bernanke spoke in Jackson Hole,” said Michael Materasso, co-chairman of the fixed-income policy committee at San Mateo, California-based Franklin Templeton Investments, which oversees $261.2 billion in bonds.
Materasso says he prefers corporate debt securities, emerging-market bonds and commercial mortgage debentures to government debt. “There are better opportunities in U.S. bond market than Treasuries.”
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