ANALYST: The Past Two Weeks Were A Preview Of The 'Horror Movie' Coming To The Bond Market This Summer

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Over the past few weeks, attention in financial markets has once again turned to the prospect of the Federal Reserve tapering back its monetary stimulus, spurred on by public speeches from Fed presidents and articles from WSJ reporter Jon Hilsenrath, who is viewed as close to the central bank.

As concerns that the Fed may begin exiting the bond market this year have risen, investors have unloaded bonds, causing a swift back-up in interest rates.

Of course, if that sort of thing happens when there is merely talk of tapering stimulus, investors rightfully wonder what would happen if the Fed were to actually begin tapering.

Société Générale fixed income strategist Vincent Chaigneau writes in a note to clients that “this was just a sneak preview of the horror movie that we see coming out this summer: a nasty Treasury sell-off.”

Here’s Chaigneau:

Less, not more QE. Two weeks ago in the FI Weekly, we thought it was premature to be aggressively short, but we presented trades that were most appropriate to position early for a sell-off. The sell-off did come early. Economic data has improved since the 3 May employment report. This has pushed forward short-term rates higher. 10y UST have sold off disproportionately … highlighting the impact of the Fed exit debate. Fears that the Fed would soon taper QE have returned, causing a harsh bear steepening.

But no Fed turn just yet. The WSJ’s article from Hilsenrath on the Fed mapping exit from QE3 refocused minds away from the dovish interpretation of the FOMC statement, where the Fed said it could do more or less QE. Even a dove like Williams is starting to talk about tapering QE this summer. Still, in our view, the Fed is only doing an early check of the market’s function reaction. The lesson: the market is sensitive; managing a smooth exit won’t be easy for the Fed. It will have to exit eventually, but there is no hurry: inflation has been subdued, and Q2 is still going to be a weak quarter for growth. 

The data calendar is very light in the week ahead, but Wednesday promises to be exciting: we’ll have both Bernanke testifying before the Joint Economic Committee on the economic outlook and the Fed Minutes (we’ll see if they had a bias towards more or less QE)…

We don’t think Bernanke will strongly lean on the side of “less QE” just yet on Wednesday, though there is a (small) risk that the recent Fed’s leaks and talk are aimed at preparing the market for somewhat hawkish Minutes. In all, we don’t see 10-year UST yields breaking above the key 2.09%, or even 1.98% resistance over the coming weeks.

Chaigneau says SocGen is “very bearish” on Treasuries going into year-end – the French bank forecasts 10-year government bond yields will rise to 2.75% by the end of 2013.

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