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Quantitative Easing Could Have ‘Bad Ending’ for Certain Fixed Income Sectors

Smith Breeden Associates Director of Research suggests a rapidly recovering economy and subsequent rise in inflation could result in sooner-than-anticipated end to accommodative Fed policy


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Durham, NC – The housing recovery combined with decreasing unemployment and increases in consumer spending imply the U.S. economy is on track for an accelerating recovery—and an end to quantitative easing.  According to Greg Brown, “By our estimates, it is increasingly likely that a sooner-than-anticipated cessation of quantitative easing—spurred by significant improvement in economic conditions and a resulting ‘inflation scare’—could create a ‘bad ending’ for various fixed income markets.”  Gregory W. Brown, PhD, is Director of Research at Smith Breeden Associates, and a Professor of Finance and the Sarah Graham Kenan Distinguished Scholar at the UNC Kenan‐Flagler Business School.  Smith Breeden Associates is a global asset management firm providing a variety of traditional fixed income and absolute return strategies.
 
“The catalyst for a sooner-than-anticipated end to quantitative easing is strongly improved economic conditions concurrent with any rise in inflation that prompts an ‘inflation scare.’  It is not even necessary that actual inflation tick up much, only that inflation expectations increase and markets start to fear the end of quantitative easing,” stated Brown.  Brown reviewed Fed Policy actions and the risks associated with quantitative easing in his recent white paper, “Will U.S. Quantitative Easing End Badly?”

“While the Fed has promised to be exceptionally accommodative until the labor markets improve significantly, there is an important caveat.  The Fed has predicated its policy on intermediate-term inflation expectations remaining below 2.5% and longer-term expectation remaining ‘well anchored.’  With inflation currently running at approximately 2%, this does not leave much headroom,” Brown continued.

The potential bad ending Brown foresees pertains largely to those assets exposed to inflation risks, such as conventional U.S. Treasurys.  “The crux of the problem lies in understanding how much expected inflation would be ‘good’ for the economy and markets—perhaps as much as 3% on a forward-looking basis.  However, the combination of surprising growth and current Fed policies makes for a highly flammable combination which could lead to inflation expectations beyond this level,” said Brown.

Following is Brown’s outlook for various fixed income sectors based on a possible inflation scare: 

  • U.S. Treasurys could experience a rapid climb in yields—much like the sell-off in 1994 when bond traders were caught off-guard by Fed rate hikes.
  • Treasury Inflation-Protected Securities (TIPS) could be largely insulated from a sell-off if increases in real yields are offset by increases in expected inflation. 
  • Agency MBS would be hurt by both higher volatility and a lack of Fed buying.  Higher nominal rates will extend the duration of pass-through securities, but a strong economy will allow many currently constrained households to qualify for refinancing (via higher incomes and home prices).  This means security selection—i.e., properly valuing the unique characteristics of mortgage pools—would become increasingly important for determining returns.  
  • Corporate bonds would be adversely affected by the increase in U.S. Treasury rates, but improving credit quality would partly mitigate price changes through tighter spreads.  In particular, shorter duration, lower quality bonds would outperform longer duration, high quality bonds.


 
About Greg Brown, PhD
Gregory W. Brown is Director of Research at Smith Breeden Associates, and a Professor of Finance and the Sarah Graham Kenan Distinguished Scholar at the UNC Kenan‐Flagler Business School.  Brown’s research, which is focused on financial risk and the use of financial derivative contracts as risk management tools, has been published in leading academic and finance journals, including The Journal of Finance, the Journal of Financial Economics, The Review of Financial Studies, The Journal of Derivatives, and the Financial Analysts Journal.  Brown holds a PhD in Finance from The University of Texas and a BS with honors in Physics and Economics from Duke University.   

About Smith Breeden Associates
Founded in 1982, Smith Breeden Associates provides full discretion fixed income asset management services to pension funds, endowments, foundations, insurance companies, and central and supranational banks.  Focusing primarily on the major U.S. fixed income sectors—MBS, ABS, CMBS, corporate bonds, Treasurys—Smith Breeden’s product line includes a variety of traditional fixed income and absolute return strategies.  Smith Breeden has a 30+ year history of pioneering work in developing and applying quantitative financial analysis to valuing and trading fixed income securities, including Agency and non-Agency mortgage-backed securities.  More information about Smith Breeden Associates is available at www.smithbreeden.com



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 quantitative easing
 fixed income assets
 asset management services
 fixed income sectors
 Fed Policy


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