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Bond vigilantes ‘outmanoeuvre’ US Fed

25 November 2013

Ashmore analysts suggest US central bank unable to control investors

Federal Reserve chairman Ben Bernanke's attempts to control the long end of the curve by stressing that tapering is not the same as rate hikes has seen him lose ground in the 'battle' with bond vigilantes, according to Jan Dehn, head of research and Gustavo Medeiros, portfolio manager at Ashmore.

"The Fed's power to influence the bond market has become very asymmetric," they explained. "It is (almost) the only game in town when it comes to buying US Treasuries - in Q2, for example, the Fed was the only net buyer in the market. Therefore, rates can easily go up if the Fed stops buying. But there are limits to how high long rates will go, because higher yields have effects on the real economy."

Following the market's rough dismissal of Bernanke's verbal guidance in May, the Fed will try stronger medicine next time it seeks to taper, suggested Dehn and Medeiros. "Currently the most talked about innovation is to adopt a lower 6% formal unemployment threshold for hiking rates. Thus armed, the Fed hopes to taper again, mostly likely early in 2014, without blowing up the long end of the Treasury curve."

However, they expressed doubt that a formal lower unemployment threshold will deter bond vigilantes for three reasons:

• A lower unemployment threshold is just another verbal commitment that can be broken at any time
• Bond vigilantes know that the Fed has very little concrete ammunition to back its verbal guidance
• There is plenty of liquidity to fund speculation against the Fed and the cost of shorting the long end of the US treasury curve is quite low

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