As asset-backed securities, (ABS) and Treasury investor grapple with the Federal Reserve’s monetary policy, specifically whether the increases will happen in small or large increments, some critics of the Fed’s policy tightening course are crafting answers of their own by driving up yields through aggressive bond sale activity.
The ripple effect of the Fed’s slow short-term rate hike is already evident. The Bloomberg Financial Conditions Index is at -1.03, down from the cycle peak of 1.32 in May 2021, to its tightest measure since February-April 2020, and even tighter than the monthly close of -0.65 in December 2018, according to Bank of America.
Some critics say that the central bank’s 50 basis point (bps), short-term, interest rate hike was inadequate. They acknowledge that the Fed is moving in the right direction, but believe that the increase “was too restrained,” and a 75 bps move would have made better sense, according to a recent securitization market outlook from Bank of America Securities.
In the past 30 years, the Bloomberg Index reached meaningfully tighter levels at least five times (1998, 2002, 2008, 2011, 2020), suggesting a near-term pause in tightening is possible but not very likely when compared to historical precedent, BofA said.
How impactful are those ‘bond vigilantes’?
While Fed monetary policy is usually the guiding hand that determines market liquidity and viability, not all industry actors wait for the central bank to determine their fate.
Real yields on week-over-week 10-year Treasurys increased by roughly 25 bps, to 3.1%. This likely reflects action from the so-called Treasury bond vigilantes—in this case investors who disagree with the Fed’s pace of action in addressing the challenges of higher inflation and credit risks caused by ongoing geopolitical conditions, according to one industry source.
Whether Treasury bond vigilantes really play a tangible role in the market today, appears to be a matter of opinion.
“There is no such thing as a bond vigilante in today’s market,” said Keith Weiner, the CEO of Scarsdale, Ariz.-based Monetary Metals. Weiner, originally a fixed-income investor who expanded to precious metals, adds “there are certainly traders who can bet on rising bond prices (long) or falling bond prices (short). These traders are making short-term bets, typically with leverage.”
About “real” yields
What makes a yield “real” is a calculation not everybody agrees upon, according to some investors, including Weiner who thinks the nominal versus real rate concept is broken. “The actual rate at which an actual lender actually lends to actual borrowers” represents the "nominal" rate, he said. The “real” rate represents the difference between the nominal rate and an inflation figure that few can agree on, he said. If the bond yields 5% and inflation is running at 2%, the real yield is 3%, he said.
ABS, Rates & Treasuries
Investors say they recognize the challenges facing the Fed, especially because all ABS market segments, especially consumer ABS segments, are vulnerable to the Fed's monetary policy changes.
In the past, interest rates did not increase for any sustained period of time, Weiner said, adding that rates only increase steadily if consumers borrow more. The last time that happened was the 1970's, a period notorious for its inflation.
“I don't believe the Fed can push rates up very far, or hold them very long, before it precipitates another crisis of defaults,” Weiner said. The inverse relationship between asset prices and rate increases leads to a specific dynamic, he added, the longer the duration of a bond asset, the bigger the drop in price for each uptick in rates. “So long as the outlook is for higher rates, everything from mortgage-backed securities to corporate bonds could get hit.”
