Tim Duy and Jim Bullard are concerned that the Fed’s approach to balance sheet policy may prevent the yield curve from behaving somehow properly, by holding down long yields even as the Fed raises short rates.
So let me get this straight. The Fed is adding default-free rates duration to the market by not reinvesting maturing bonds at the same maturity as their existing portfolio. Janet Yellen claims this alone is worth about +15 bps on the 10-year UST yield in 2017. And the Treasury is adding much more duration to the market by running a reasonably healthy deficit, one that seems likely to quicken.
Meanwhile, the stock of government duration held outside the Fed has seldom been higher, nominally or relative to GDP.
But a dearth of duration – i.e. QE the effect – is why bond yields are being held down. Got it. Science!
I preferred Tim’s earlier piece in which he argued the QE unwind was not a big deal because the odds were that the Fed would calibrate it correctly. I would add — and did add — that QE does not have much effect on bond yields anyway, beyond the signaling which can be managed, and the knee-jerk reactions, which are demonstrably temporary.
It is just my opinion, but as a rule I would steer away from the premise that there is truth in the Fed’s pronouncements around these subjects that has to be incorporated into our world view. Things are clearer if you just identify it as bullshit, as Tim did so wonderfully while assessing former Fed Governor Warsh’s comments. Warsh is not the only one to fib.