Fed Pivot to Forward Guidance Furthers Bear Case for Bonds

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I remain skeptical of the “power” of forward guidance and think the switch away from QE to forward guidance as a primary policy tool only furthers the bearish case for bonds.  And, my skepticism is rooted in experience and observation.

Although the rise in the Dollar Index yesterday got a lot of press, the one currency that was stronger vs. the dollar yesterday was the British Pound, which saw a 0.8% rally vs. the greenback—and that’s something that shouldn’t be dismissed, because I believe that what’s happening with the Pound, the FTSE and UK Bonds, may provide us a “road map” of sorts for what will happen to the Dollar, Bonds and stocks, now that the Fed is switching to “forward guidance” as its primary policy tool.

The pound rallied yesterday because the November Labour Market Report was stronger than expected (the unemployment rate dropped to 7.4%).  That drop in the unemployment rate came despite the minutes of the latest Bank of England policy meeting being relatively “dovish,” as the BOE lamented the lack of productivity gains in the economy, and implied the better jobs numbers aren’t as good as they appear.

The reason this is so important and timely is because basically since July, the market has called “B.S.” on the Bank of England’s “forward guidance,” and it did so again yesterday.  That’s because the market is trading off the economic data, and it correctly assumes that regardless of what the BOE says, as the economy accelerates, the BOE will eventually be forced to remove accommodation and begin to tighten—well before the time they are currently referencing in their “forward guidance.”  This is important because the very same thing could happen here down the road (i.e. more bearish bonds).

From an investment standpoint, the case for the bond bears, of which I am one, got stronger yesterday over the medium term, as I firmly believe that the policy pivot by the Fed to forward guidance will eventually result in an acceleration of the decline in the bond market, like it has done in the UK.  So, if there is any sort of “buy the taper news” reaction in the bond market over the next few days, I would use it to add to positions in TBT and TBF, because bonds are still clearly in a downtrend.

For the stock market, on balance the Fed yesterday was a mild positive surprise as the strong forward guidance more than offset the small taper.  But, while that is a positive, it doesn’t mean any material positive change in the outlook for the Fed or market (point being, despite the rally, yesterday’s FOMC announcement wasn’t a bullish game-changer).  Year-end positioning and sentiment continues to be an underappreciated influence on the markets, and I got the feeling that yesterday’s rally into the close was more do to managers wanting to maintain participation in the market than it was a hugely bullish vote of confidence.

Going forward, the key to watch remains the short end of the yield curve and the ETF SHY.  Bottom line is taper is not a rally killer as long as the rise in rates is “orderly” and the market believes in ZIRP, and we’ll know that by watching SHY.  If SHY begins to materially sell off, that will be the tell-tale signal that the rise in rates is becoming equity market negative.

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