Bernanke's Bind

 | Jun 18, 2013 | 5:00 PM EDT
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The increase in long-end U.S. Treasury yields this year has been aggressive and accelerating -- and it might get worse. It began with the Jan. 3, 2013 release of the minutes of the Dec. 11-12, 2012 Federal Open Market Committee (FOMC) meeting. Several voting members expressed reservations about inflation potentially accelerating more rapidly than the Fed is comfortable with, or is good for the economy, by implementing the quantitative easing (QE) action calling for the purchase of $45 billion worth of long-end Treasuries each month.

The apparent dichotomy between voting for quantitative easing (QE), which was released three weeks earlier in the statement following the FOMC meeting, and the reservations about doing so (which was disclosed in the minutes three weeks later -- by those same members), shocked traders of all asset classes.

This became the catalyst for the growing rumor that the Fed was preparing to remove QE at the same time it was increasing it. This belief has only increased as the inflation hawks on the FOMC have been far more vocal this year about their certainty that QE should be removed than the doves have been that it should not be.

Bond traders have cautiously heeded the message implicit in the sound of silence coming from the doves, including Fed chief Ben Bernanke. They have caused 10-year Treasury yields to increase from 1.86% before the Jan. 3 minutes release and the 2.20% level that prevails today.

The biggest action has actually taken place in the last few months. It appears that what may have caused Treasury yields to begin to increase is becoming a self-validating vicious cycle that is affecting asset classes globally, and, most appropriately, sovereign bond yields.

The catalyst for the abrupt increase in Treasury yields over the past few months appears to be the massive $17 billion bond offering on April 30 by Apple (AAPL), which coincided with the 2013 lows for Treasury yields.

Although corporate bond offerings had been steadily increasing all year as companies sought to access cheap capital, the Apple deal, because of its size, appears to have been viewed as the trigger sending the message to corporate CFOs that if you are going to get cheap money you had better do it soon.

This has also caused bond spreads to begin to increase as companies seek to attract bond buyers in a market where expectations for rising yields is causing them to shy away from buying.

On Monday, Chevron (CVX) came out with $6 billion bond offering, $2.25 billion of which was priced at 100 basis points above 10-year Treasuries. This allowed buyers to come with capital acquired by shorting the Treasuries to buy the Chevron deal. This activity helped move the 10-year Treasury yields up on the day from 2.11% to 2.19%.

This caused mortgage rates to rise incrementally, driving out the duration of mortgages and mortgage backed securities and forcing portfolio managers to short treasuries, too. I discussed this process, known as convexity hedging, in my May 29 column, We're Avoiding a Vicious Spiral, for Now.

The rise of U.S. Treasury yields caused by these two events is also causing the international carry trade market to reverse and sending sovereign bond yields in many other countries up as investors close out their carry positions. If done properly, a carry trade is a risk-free financial arbitrage, wherein the net cost of capital on one side is more than offset by the financial return achieved with the borrowed capital. The most common today is the yen carry trade, in which money is borrowed in yen at low rates, converted to U.S. dollars and invested in U.S. Treasuries at a higher yield. Putting that trade on causes yields in both countries to decline. Reversing it causes them to rise.

Right now, the bond offering, convexity and carry trade issues are all feeding back into each other. The risk is that yields could soon spike. Pushing this process along has also weakened the Treasury auctions of the past few weeks.

Bernanke is caught between having to decide to risk asset bubbles and the ramifications of them by continuing QE as it is currently structured, or risk a vicious spiral in bond yields and a capital market crash now by continuing to allow the bond markets to believe that the Fed is going to begin to withdraw QE soon.

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