With all the excitement over the Fed’s Taper of QE3 yesterday, it is beginning to dawn on bond market investors that someone will need to come in and pick up the slack in demand caused by the Taper. In January, there will be $5 billion in Treasury bonds and $5 billion in mortgage-backed bonds that would be normally scooped up by the Fed that will need to find a buyer.
When the Fed began QE3, Treasury bonds were on the cusp of entering a secular bear market after enjoying a secular bull market for the previous three decades (see the charts above). However, because it was early (and because investors weren’t listening to our warnings!), investors were still piling into bonds and bond mutual funds. It was hard to break a habit that had been so fruitful for 30 years.
As a result, at the beginning of QE3, the Fed was essentially “crowding out” relatively enthusiastic bond buyers.
Now, 16 months after the Fed starting buying mortgage-backed bonds and 12 months after the Fed started buying longer-term Treasuries, investors are transitioning out of these areas and into equities and other higher-yielding investments. Besides being lured by better returns elsewhere, who wants to buy a 10-year Treasury and get hammered as market rates really only have one way to go?
The bond market vigilantes have already begun to make an appearance, selling longer-dated bonds this morning rather than holding on to them into January when it might require an even higher yield to entice very reluctant investors to soak up the $10 billion in excess supply.
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