ZIRP to potentially remain in effect through 2017

Spoke about this with a few people yesterday. It's very clear the Fed wants to stop asset purchases without a similar rise in rates that we saw in 2Q because of the drastic affects we saw on housing, basically having their cake and eating it too. This is a possible strategy, but I think the Fed giving hard forward guidance ("early 2016") along with a tapering announcement the meeting before execution would likely be more efficient.

The one thing I’m interested in is that Bernanke was much more democratic than Greenspan, who basically wrote the Fed statement the night before the meeting, then let the members argue for three hours before making the statement. Yellen is much more in the Bernanke democratic camp, so the outcome of the meetings are a little harder to judge.

Here are the 2 referenced papers by the way (both open in .pdf):

LINK

LINK

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Realistically, how closely linked are tapering and rate increases?

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You'd expect them to be very closely linked. Purchases of treasuries and MBS drive the prices of those securities up and rates down. Less purchases might then be expected to drive rates up (generally speaking).

As Benny said, the Fed is (could be) trying to offset this natural upward pressure on rates by essentially signaling to the market that the Federal Funds rate will remain in the 0.00-0.25 range.

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Is that how it's being understood by the fixed income crowd? Looks like bonds were a little jittery on the "news" yesterday.

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The belly (5-10 years) will be most affected by good data and the tapering announcement, mainly because this portion of the yield curve had the highest allocations of purchases for QE2, OpT2, and QE4. The short-end will stay anchored because of the Fed Funds rate, but also because there is simply a shrinking universe of short-term securities and short-term funding/trading. CP issuance is down since '07, T-bill issuance is down with a shrinking deficit, IG issuance is long because of lower long-term rates, repo trading has shrunk marginally with a decrease in liquidity/risk taking by dealers, and the list goes on.

Honestly even though the short-term hit will be bad for fixed income returns, intermediate and long-term rates rising is actually pretty welcome. If you have a 5-year yielding 2-3% and a 2-year yielding 0.50%, you can pick up ~2% of 'roll-down' just by holding the bond for 3-years, which is separate from your duration/coupon returns too. Investors are going to keep pulling from fixed income if rates continue to stay low.

That's good color, Benny

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Would the ZIRP still be able to hold rates down?

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The front end, yes. Anything past 2-years, not really. So many front-end instruments are benchmarked to the Fed Funds rate. Usually there is a range around the Fed Funds target rate that the actual rate will trade around, but with the implementation of the Fed's fixed-rate reverse repo facility, that range will essentially cease to exist soon.

The Fed can control the steepness of the curve with ZIRP but not necessarily the overall level of 30-year rates. That being said, the 10-year rate has NEVER risen 400bps above the lower range of the Fed Funds target rate, so you can look at 4.0% as a ceiling for the 10-year right now.

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I'm guessing with ZIRP controlling the steepness of the curve but not the levels, roll down will continue to be the play. Could the resulting total return for the 10 year issues be in the (maximum) 5 to 6% range, duration/coupon returns plus roll down?

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Yep, 100%. Find the steepest part of the curve coupled with the highest yield per unit of duration and go home happy (assuming no view on changes in rates).

I mean, this is all made on a multitude of assumptions plus we actually have to get to those levels first and experience the mark-to-market losses as well. Wouldn't call your weekend made based on that