Will Fed Trigger Bond Sell-Off?

The first two rounds on quantitative easing from the Federal Reserve were good for stocks and bad for bonds.

The Federal Reserve headquarters in Washington, DC.
The Federal Reserve headquarters in Washington, DC.

Amid fears of deflation, the Fed stepped in and began pumping money into the system by buying US Treasurys, reversing a decline in bond prices with the extra cash that flooded the system.

The big question for the bond market now is whether an end to the second round of quantitative easing (QE2) will see a sell off in the bond market that will drive up borrowing costs for the Federal government and American homeowners.

“When the Fed discontinues its government bond purchase program at the end of June, a large portion of current demand will disappear. The Fed purchased more than 60 percent of all traded US Treasuries in the fourth quarter 2010,” said Alessandro Bee, a fixed income strategist at Sarasin in Zurich in a note to clients on Wednesday.

“Experience gathered over the last two and a half years shows that expectations were more important than supply and demand. Once the starting shot for QE1 and QE2 was fired, yields in each case rose, despite the added demand for bonds caused by the Fed’s action,” Bee said.

“Although the gradual increase in core inflation and the robust economic prospects suggest higher interest rates during the course of the year, a selloff triggered by the shift in demand is very unlikely,” he added.

Who Will Replace the Fed?

If the Fed stops buying US debt then someone will need to pick up the slack, something that might not happen given fears over the sustainability of the federal deficit as highlighted by S&P’s decision to put US debt on a negative rating outlook last week.

“The US is still not expected to consolidate its budget in the second half of 2011,” said Bee who believes the only groups who can step in and buy on a scale that would offset the Fed exiting the market are US households and foreign central banks.

“Commodity exporters and major Asian exporters are the biggest players in the US government bond market. These countries combine two attributes: they have high trade surpluses with the USA and do not want their currencies to appreciate against the US dollar,” Bee added.

As the Fed removes its unconventional support in the second half, Bee expects riskier assets like commodities and equities to encounter more difficult trading conditions.

“US Treasuries, in particular, are likely to be chosen in this environment,” said Bee who believes the flight to safety will override fears over the credit worthiness of US debt.

“As long as the currencies of key commodity exporters and emerging market countries have a strong link to the US dollar, demand for US Treasuries is likely to remain elevated,” he added.

“Furthermore, US household demand for government bonds should pick up. Relatively speaking, the more challenging environment for risky assets puts government bonds in a more attractive light,” Bee said.