Recap 2014-09-25: HY & SPX; Why Ending QE Does Not Mean Higher Yields


The rise in US real yields are not only driving the dollar, but also outflows from REITs and high yield. The chart below shows how 5y real yields have been leading the HY CDX for most of the past 12 months:

This makes sense – real yields are a major driver of default rates over the cycle, although of course the size and severity is a function of a multitude of other factors. However, real yields have fell somewhat, and multiple Fed officials (Dudley, Evans, Lockhart, Mester) have noted that dollar strength could weaken growth / inflation the past few days. Furthermore, it’s worth noting that CDX HY is now at the top end of a range that has prevailed for about 11 months:

And over that period, those observations have been decent entry points for equities: (in orange below. CDX HY is in white and inverted)

A natural question at this juncture is whether it’s appropriate to assume that recent trends will persist given the end of QE. Bond bears seem to be out in full force, at last ending their long hibernation. I strongly disagree.

Bond yields reflect a clearing level where the amount of money asked/offered by borrowers and lenders balance. There has been a lot of talk about how the end of Fed buying will decrease the amount of lending. Less attention has been attached to the fact that borrowers are not borrowing! Look at demand for mortgage loans, for example. They have been stuck at levels not seen since 2008! And the story is similar in municipal space:

That segues to this great post here about how supply and demand impact prices:

The fact of the matter is that humans think iteratively, which is useful in microeconomic situations, (where only one or a few transactions occur) but inappropriate for macroeconomic situations. (where many, many transactions occur, often in a connected fashion) Because markets move to a clearing price – and in fact keep moving until they do – macroeconomic models are actually much better to understood via a recursive framework. The most common thought about the end of QE is that there will be less demand. Thus, yields must go up, QED. (The head of GSAM reportedly said something like this today) But that’s just too short sighted. The fact is that essentially all market participants know that QE is ending, both borrowers as well as lenders, and they have already adjusted their plans accordingly. Many borrowers have already borrowed over the past few years to take advantage of low interest rates (i.e. future fixed income supply will be lower) and many lenders have put off lending because they only find it economical to lend at higher yields (i.e. future fixed income demand will be higher) The quantity of buyers, in and of itself, (i.e. knowing that the Fed will reduce buying) is essentially meaningless without also knowing the function for the quantity of sellers at that price. As the Philosophical Economics post above shows, there are many situations where the supply to demand ratio can change massively without a major impact on the clearing price. Looking only at future supply or demand as a way to trade rates has historically been 100% wrong – case in point: the federal budget deficit (i.e. the net amount the federal government borrows every year) has historically been strong negatively correlated to yields. And if Japan is an example at all, note that JGB yields peaked at the same time the BoJ balance sheet started falling:

I’m not saying that the end of QE won’t have any hiccups. Arguably we are seeing QE related disruption already. What I am saying is that expectations of higher yields simply because QE is ending is just incomplete.

Some other interesting links:

Interesting Post on Amazon’s business model – sounds like Alibaba, doesn’t it?

Great dive into the Stock Buyback data:


  • US Jobless Claims declined to 293k vs 196k exp and 280k prev
  • Core Capital Goods Orders rose to 0.6% vs 0.4% exp. The prior print was revised up to -0.2% vs -0.5%
  • Markit Services PMI
  • Russian draft law would allow seizure of foreign property – Reuters
  • Russia’s repeated incursions into Baltic air space rattles NATO. Russian fighter jets are increasingly making “provocative” incursions into Baltic air space and NATO is becoming worried. NATO fighters policing Baltic airspace were scrambled 68 times along Lithuania’s borders this year, by far the highest count in more than 10 years. Latvia registered 150 “close incidents” – FT
  • China plans to connect the Shanghai stock exchange to its counterpart in Hong Kong over the next month as part of an initiative announced by Premier Li Keqiang this year to open China’s markets to foreign investors who have been largely shut out. The move will allow foreign investors to trade the shares of companies listed on the Shanghai stock exchange directly for the first time, and mainland Chinese investors to buy shares in companies listed in Hong Kong. – Dealbook


  • Thu: Japan CPI
  • Fri: German & French Consumer Confidence, U Michigan Confidence
  • Sun: Bernanke Speaks
  • Mon: German CPI, US Core PCE, Pending Home Sales, NZ Building Permits, UK GfK Consumer Confidence, Japan Jobless Rate, NZ Business Confidence
  • Tue: Month End, UK House Price, EU Employment, EU CPI, Canada GDP, Chicago PMI, US Consumer Confidence, Japan Mfg PMI, AU Retail Sales
  • Wed: EU PMI, US ADP, ISM, Australia New Home Sales, Building Approvals, Trade Balance
  • Thu: ECB, US Jobless Claims, Australia Service PMI, China Non-Mfg PMI, Japan Service PMI