Is The Fed’s Grand Confidence Game Coming To An End?

I was dead wrong when I recently wrote “how I stopped worrying about interest rates and learned to love the long bond.” Since that time long bonds have dropped almost 10% in response to the Fed disclosing it wishes to “taper” is $85 billion per month in bond purchases. In fact, my timing could hardly have been worse. I will say I’m glad I took my losses quickly and avoided the majority of the decline over the past couple of months.

Still, I’m watching the bond market like a hawk these days. Since Bernanke started the “taper” talk the surge in interest rates has been dramatic and it has all sorts of implications for other asset classes.

tnxLet’s put it into context. The rate on the 10-year Treasury bond has risen from 1.65% at the end of April to 2.9% today. This may not seem like much but when you consider that this rise amounts to a 75% increase in our government’s cost of capital over a period of three months you start to understand how significant it really is.

In addition to the government, it’s also been significant to investors. Income-based investment classes that have appealed to more conservative investors like REITs, preferred stocks and utility stocks have all been negatively affected by the surge in rates handing these investors losses they probably didn’t imagine were possible.

There are hints that Asian markets may be affected, as well. After surging through the first few months of the year Japan’s Nikkei now looks vulnerable to a significant decline and emerging Asian markets like Indonesia (fell nearly 10% this week) have already begun to show serious signs of distress. I can’t say for sure that these are related to the interest rate surge but it’s very possible that it’s more than coincidence. We are a world economy and you know what they say about a “butterfly flapping it’s wings in the Treasury bond market….”

What I find most fascinating is that beginning soon after the “taper” talk the Fed became much more dovish in its communications and rates STILL continued to climb. On Wednesday, for example, the Fed minutes included this statement: “Almost all committee members agreed that a change in the purchase programme was not yet appropriate” making it fairly clear the committee doesn’t intend to taper its bond purchases. STILL rates surged on the announcement.

This market action suggests to me that “Bernanke’s Grand Confidence Game” may be coming to an abrupt end. Over the past few years it’s very clear the Fed’s bond buying programs gave investors the confidence to push all sorts of risk assets to record highs. It’s very possible, however, that these same investors are now losing confidence in the Fed’s willingness, and perhaps its ability, to backstop them. In fact, it looks to me like they now have decided to front run the Fed’s unwinding of its bond buying programs and this is a very dangerous game.

I recently wrote, ‘should stocks and bonds begin to fall in tandem I’ll begin to worry that the marginal demand for risk assets that has been inspired by the Fed’s actions could evaporate very quickly.’ This is exactly what’s begun to happen over the past couple of weeks. Stocks have peaked as bonds have been slaughtered and I have indeed begun to worry that the end game is near.