It’s hard to over-emphasise the potential fallout as Treasury market participants race to the exits, giving up on the QE3 dream.
Bonds have been in a 30-year bull market, with long-term yields falling more-or-less constantly since the early 80s. Five-year yields hit a record low just six weeks ago.
The bull market might not be over yet but for top-pickers, it’s difficult to imagine an easier call. Rates have pushed to fringes of possibility with interest rates nearly at zero and $2.2 trillion of quantitative easing. Two-year yields fell as low as 0.20% and longer-term rates are well-below the rate of inflation.
Everyone knows that rates are headed higher but the question is, when? Long-term yields might be low but they have been in this range for the past six months.
Fast money has been waiting to get short bonds but QE3 talk has kept them from pulling the trigger… until now. If rates continue to run, real money will be squeezed and forced to answer questions about the wisdom of locking money into Treasuries for 10 years at 2%.
How high could rates go? Historically, 10-year yields track or exceed nominal GDP. With that measure expected around 4.0% this year, the bond market could be in for a much rougher ride than the 20-30 basis points of selling this week. In 12 months we could be talking about the Fed raising rates and a QE exit strategy.
For the forex trader, the takeaway is that the US dollar is no longer a carry-trade funding currency. This has major implications. Never underestimate the size and power of trades that borrow cheap in one place and invest richly in another. In the credit crisis, NZD/JPY fell 11% in a single day as carry trades were unwound.
It should be no surprise that carry-favourites AUD/USD and NZD/USD are slumping at the moment. If yields continue to rise, large and long-term speculative positions based on yield differentials will be taken off. This is likely just the beginning.
The real winners will be USD/JPY and USD/CHF, which will easily reach 90 and 100 (respectively) if 10-year rates get to 3.0/3.5%.
Volatility is another takeaway. Money will flow out of bonds and into stocks but not just US stocks. International flows will be a growing risk and M&A will increase. Look especially to Japan where the government is encouraging companies to takeover foreign rivals.
With a potential turning point in focus, Fed musings will grow increasingly important. The Fed may not have hinted at QE3 on Tuesday but they didn’t rule it out either. If borrowing rates climb 100 basis points it will hurt US housing and corporate balance sheets. Bernanke has consistently taken the more dovish route and there isn’t enough evidence to say this isn’t a premature, warm-weather-induced, technically-driven head fake yet. But it’s close.
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