Eventually you can’t keep making the same “frontrun the Fed” trade over and over again, because everyone knows what the Fed is going to do, and everyone has made the same trade.
Goldman has already argued that QE is priced in, and so too is Nomura’s George Goncalves, head of US Rates Strategy
Many believe that in an environment leading up to QE2, investors should buy what the Fed is buying because this will guarantee returns for bond investors. We tend to disagree. We believe rates will find equilibrium based on supply/demand and fundamentals and that is what will determine bond valuations. In our opinion, once the Fed is successful at improving economic conditions, we will see higher rates and lower total returns for investors that buy bonds at the lows in yield. Bonds will only retain their returns if the Fed fails at turning the economy around (ala Japan).
It is always a challenge to determine how much of a news event is priced in, but we believe that a significant amount of the QE2 announcement effect is already reflected in market prices. We believe the QE2 impact is going to come in waves, as it did in QE1 (but again, once the Fed is proven successful, rates will not drop— they will rise as they did in 2009). We must remember that the road to more QE is a process, and in that process from announcement to implementation, we will see yields react accordingly.
In fact, the market has already began responding to this QE chatter. The first impact came from the QE-lite transition, when yields dropped 40 bps in August. Then, markets shifted in reaction to the September FOMC meeting easing bias, and yields have since dropped 15-20 bp. Although we could see yields initially decline after a Fed easing move in Q4, buying Treasuries now for a one-time only trade into a Fed QE event is risky and not a sound, long-term investing style (especially if the Fed’s goal is to generate growth, which will ultimately require inflation). Therefore, unless investors believe that buying alongside the Fed is a view that the Fed easing policies will not work and thus deflation will win out instead, we do not advocate chasing yields lower.