The Fed's announcement Wednesday to begin the tapering of its bond buying program (to our surprise) has been followed by a spike in the US 10 year yield; however, Citi's FX Technical group cannot help but feel that we have seen this dynamic play out before
Via Citi FX Technicals,
Previous endings of the Fed’s bond buying programs have seen a quick spike in yields that proves to be short-lived as the reality of a still weak global economic backdrop takes hold.
If history is any indication, it would not surprise us to see the US 10 year yield top out over the next few days before turning lower towards 2.40%-2.47% and potentially continue declining towards 2.00%.
The pattern here is rather clear: introductions of unsterilized bond buying programs by the Fed lead to a sell-off in Treasuries (rally in yields) while the ends of these programs lead to a rally in Treasuries (decline in yields).
(We exclude Operation Twist as it was a sterilized program which did not actually expand the Fed’s balance sheet).
It is clear to us that the introduction of QE leads investors to sell Treasuries (classic buy the rumour sell the fact) and rush into riskier assets on the back of the search for higher yield and the implicit market (Greenspan/Bernanke) put that promotes complacency and financial asset inflation.
Once that market put is removed, though, the economic backdrop becomes the bigger driver of investor sentiment. At the end of both QE1 and QE2, the US recovery was still very weak and the European sovereign crisis was taking hold.
While the current economic backdrop is certainly better than that seen during those periods, we still remain in an environment where
– The US recovery remains weak by historical standards as unemployment is still elevated and the quality of jobs created is poor, core PCE is near historical lows, corporate earnings growth is based on margin compression rather than sales growth, the housing recovery is tepid at best and 30 year mortgage rates remain at the highest levels seen since mid-2011.
– While fears around the European sovereign crisis have been put on the back burner, the reality is that none of the structural issues which have affected Europe have actually been resolved.
– The recent spike in yields has shed light on the weakness of many emerging market countries that had previously been highly favored. In our view, going forward, emerging market investments will likely be done selectively and with more caution as investors adjust to the removal of the Bernanke put. This could put pressure on many of the fundamentally weaker countries which rely on foreign financing. In line with our views expressed earlier, this could lead to flows back into the USD and US Treasuries.
– Oil prices remain high and show no signs of declining in the near term. This (along with higher yields) can serve as a drag on the economy, the negative feedback loop of which would also suggest lower yields going forward.
On the back of all of this, we would not be surprised to see one last move higher in the US 10 year yield over the next few days, potentially as high as 2.95%-3.00%, the converging downward sloping trend line (see previous page) and the 2013 high. However, such a move would, in our view, likely be the medium-term top and if history is any indication, a move lower in yields from there would be likely, especially given our concerns with respect to the global economic backdrop.
While we do not necessarily expect a move similar in magnitude to that seen at the end of QE1 or QE2 given both the pace of tapering and the slightly better economic backdrop, a move towards 2.40%-2.47% seems likely (those levels are the converging 200 day and 200 week (not shown) moving averages, the October 2011 and 2013 highs and the October 2013 lows).
The 2.47% level also serves as the neckline of a potential double top and a break below there would confirm the pattern, which would then target just below 2.00%. As we have previously pointed out, The US 10 year yield has historically had a tendency to top out while posting a double top.