As it did last September, the Fed threw the markets a curveball. Whereas the Fed surprised the markets by not tapering last September, the Fed once again surprised the markets, this time by tapering.
The FOMC announced that, beginning in January, the Fed will purchase $75 billion of U.S. Treasuries and mortgage securities, cutting purchases of each by $5 billion. As the same time, the Fed took steps to extend forward guidance for tightening interest rate policy. In its statement, the Fed said that the Fed Funds Rate could remain in its current range of 0.00% to 0.25% “well beyond” the point the Unemployment Rate reaches 6.5%. During his press conference, Fed Chairman Ben Bernanke explained that an Unemployment Rate of 6.5% would be when the Fed would look at other jobs data for signs that tightening interest rate policy is appropriate. The Fed also indicated that rate policy could remain extremely accommodative as long as inflation is trending below 2.00%. The Fed’s forecast for inflation in 2014 is in the 1.4% to 1.6% range (down from 1.8% at the September meeting). The Fed’s 2015 inflation forecast is for a range of 1.5% to 2.0%.
Jobs were central to the Fed’s decision to taper. The Fed’s statement cited recent improvements in hiring. However, Mr. Bernanke expressed concerns that structural changes in the economy could slow the pace of hiring, at least temporarily.
The Fed’s forecast for 2014 GDP growth was revised to a range of 2.8% to 3.2%, from a prior estimate of 2.9% to 3.1%. The Fed revised its forecast for the year-end 2014 unemployment rate to 6.3%. Fed officials project the economy will strengthen further in 2015, to the 3.0%-to-3.4% range, before GDP growth eases a bit in 2016, to between 2.5% and 3.2%.The Fed’s forecast is consistent with our view that the economy will continue to heal at a steady, but unspectacular, pace.
The Fed’s statement indicates that more members were in favor of keeping the Fed Funds Rate unchanged for a longer period of time than at the September FOMC meeting. Only two Fed officials now say the benchmark Fed Funds rate will be increased in 2014, one fewer than in September. The latest information indicates 12 policymakers expect rates to first increase in 2015 (unchanged from September). Now three say the federal funds rate will first rise in 2016, up from two in September.
Mr. Bernanke intimated that asset purchase reductions could come at a $10 billion pace, but cautioned that asset purchase reductions might not happen at every FOMC meeting. The Fed could pause if the data indicated that a pause was necessary.
Mr. Bernanke weighed in on asset bubbles. When asked by a reporter at the FOMC press conference if asset bubbles exist. Mr. Bernanke answered; not to the extent that they are problematic. He did warn of asset price volatility when these overvalued long positions “unwind.”
The end result of today’s Fed decision to taper is that monetary policy remains extremely accommodative. The Fed will continue to infuse $75 billion of monetary stimulus into the economy (at least for now) and could keep the Fed Funds Rate unchanged into and, possibly through, 2015.
Let’s put this into perspective. Prior to the current sluggish economy, a neutral Fed Funds Rate was considered to be about 4.00%. Even if we acknowledge that, in the “new normal,’ a neutral Fed Funds Rate could be in the 2.00% to 3.00% range, Fed policy could remain accommodative through 2017. We are not even within an ICBM shot of neutral monetary policy.
The bond market shrugged off the news of the taper as a $10 billion taper (if not more) was already built into to long-term interest rates. After all, long-term rates are already about 125 basis points higher than where they were prior to the first “taper talk” last May. Combine that with the fact that Treasury debt issuance has been lowered and it becomes apparent that a $10 billion taper is not enough to send long-term rates skyward. The yield of the benchmark 10-year note bounced around a bit, but ended the day at 2.896%, fairly close to the 2.90% area we predicted if the Fed tapered. However we never came close to the 3.00% level at any point. In spite of the taper, long-term rates are being held in by a reduction in U.S. debt issuance and a Fed Funds Rate in a range of 0.00% to 0.25%. The yield curve could have difficulty steepening much more than it is now.
The equity market rallied sharply following the Fed’s decision. Equity market pundits credited the rally to the Fed’s taper indicating that the economy is strong. We believe that the equity market’s positive reaction was due to the extended guidance for rate policy. Although the Fed probably wouldn’t have tapered if the economy had not shown signs of improvement, the Fed probably would not have extended forward guidance if it thought the economy was nearly out of the woods.
Accommodative interest rate policies could support risk assets in the near-term. However, when the so-called “big boys” decide that asset prices have gone high enough, the correction could be swift. We see this as a time to move up in quality from high-risk to moderate risk assets.
Taken as a whole, this was a dovish move by the Fed.
By Thomas Byrne – Director of Fixed Income – Investment Consultant
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.
High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
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