The Fed Tapering Playbook – Bill Gross Style

December 5th, 2013 by

Fed Fund Rate

On December 17, 2013, the FOMC will have its next meeting regarding the future of its bond purchasing program. The minutes of this meeting will be swiftly devoured by the market, with the hopes of having the holy grail of all questions answered: When will the Fed taper?

 

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The close watch that the market has on the Fed’s every move reflects the importance and weight investors place on the Fed’s monetary policy decisions. Although this importance sounds logical, I beg to question: are we paying too much attention to the Fed’s decision to taper with respect to our investment decisions?

Bill Gross, Manager of PIMCO’s Total Return Fund, believes that short-term Treasury yields will remain the same despite Fed tapering (see here). In other words, the nation’s most prominent bond investor believes that Fed tapering will have little no effect on interest rates.

Now why does Bill Gross think that?

The answer lies in the unemployment rate threshold, an unemployment rate figure that will essentially make the Fed happy with the state of the economy.  Based on central bank correspondence and economists’ opinions, that threshold is likely around 5.5% — a significant distance away from the 7.3% reported unemployment figure in October.  Bill Gross has supported his argument by concentrating his fund in more short term Treasuries (maturing in three to five years), while reducing exposure to long term Treasuries. His rationale for this long-for-short substitution is as follows: The Fed wants two things: lower unemployment and lower bond purchases. To accomplish the former, the Fed would need to keep the Fed Funds Rate at near-zero for the additional stimulus. To accomplish the latter, the Fed would need to reduce bond buying. Put them together and the most logical solution for the Fed would be to continue purchasing short term Treasuries (keeping the Fed Funds Rate floored) and reduce its purchases of long term Treasuries (effectively lowering monthly bond purchases).

What would a “low unemployment threshold” and “tapering” environment look like?

Firstly, the cost of borrowing will not increase, as the Fed Funds Rate (base rate in the economy) will continue to be held down by the Fed. Secondly, the long-term Treasury bond market would begin to see lower demand due to the Fed’s tapering. This will cause long-term bond prices to fall, yields to rise, and a likely movement of capital from the stock market to long term Treasuries – fueled by the fact that investors can finally enter these bonds at a reasonable price, and enjoy the inherent safety of a government-backed fixed-income security.

The Fed has urged market participants to not view tapering as any form of monetary tightening. The Fed is certainly correct in their message, but regardless, there is undoubtedly going to be confusing as to why the Fed is saying one thing and seemingly doing the opposite. To make matters worse, this confusion will likely be amplified if we experience a stock market price drop from investors flocking toward now-affordable long-term Treasuries. This situation will certainly test the Fed’s ability to communicate swiftly, clearly, and with confidence to the general public. It’s going to certainly be interesting to see what happens on December 3rd. I wonder how many investors are taking a page out of Bill Gross’ playbook and allocating funds from long-term to short-term Treasuries.

About Ali Beydoun
ali

Ali Beydoun graduated from Manhattan College with a Bachelor’s Degree in Finance. During college, Ali was appointed to manage the $17,000 business school student portfolio as a sophomore, where most of his free time was spent joyously reading annual reports, industry surveys, and other financial literature.

Immediately after college, Ali joined CBS News as an Analyst, where he advised on product strategy for the satellite news gathering service: CBS Newspath. After his tenure at CBS, Ali continued following his passion for investing and joined the Alternative Investments Department at Fidelity Investments (where he currently works). Ali is an avid reader of bond investing strategies and is always seeking ways to broaden his knowledge base.

 

 

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