The Beginning of the End?

June 26th, 2013

by Eric Schaefer

This appears to be the question investors are asking on the subject of the Federal Reserve's policy of easy money. Ambiguous statements by Chairman Ben Bernanke following the last Federal Open Market Committee (FOMC) meeting (June 18th to 19th) seemed to have tipped the scales in investors' minds, leading them to conclude interest rates will soon be going higher.

So, in a fit of a self-fulfilling prophecy come to fruition, investors have pushed the benchmark 10 Year Treasury Note yield up 31 basis points (bps) since the FOMC adjourned. Even before the meeting convened, market anxiety sent intermediate and long-term Treasury yields steadily higher. Since year-end 2012, the 10 year note yield rose from 1.78% to 2.19% on June 17th and then higher to 2.51% on the 21st.

Our suspicion is investors may be reading too much into the press release. Indeed, the committee's comments are a studied exercise in bureaucratic ambiguity, saying much and yet saying nothing at all. Yes, the committee feels the economy is growing; but only at a moderate pace with the unemployment rate still elevated. Yes, the committee must begin to consider when and how to wind down the central bank's policy of quantitative easing. But, for the time being, the FOMC is contemplating no change to the size and pace of its purchases of agency mortgage-backed and treasury securities. And, yes, the majority of committee members believe monetary policy may begin to return to a normal stance (whatever normal is) by 2015 at the earliest. But, the committee's expectations for the federal funds rate are based on some rosy projections of economic growth.

The committee's range for the federal funds rate has narrowed. In March, two committee members still believed the rate would exceed 3% by year-end 2015. Today, 3% is the outer limit. The majority of the committee's members (15 out of 19) believe the fed funds rate will be 1.50% or less by year-end 2015. Furthermore, most committee members (13 out of 19) believe the first increase from the fed fund's current range (0 to 0.25%) will occur in 2015 at the earliest. In comparison, during the December meeting 12 (of 19) voiced that opinion. In other words, there has been no significant shift in the committee's expectations.

What this means is that for the foreseeable future, there will be no dramatic move higher in the fed funds rate; and, even when a hike occurs, it is unlikely to be large. For some perspective consider that over the five years ending June 2008 (just prior to the financial market meltdown), the daily average fed funds rate was 3.25%. So, even an abrupt move to 1.50% in 2015 still leaves monetary policy in an accommodative stance by historical standards.

We suspect the Fed will begin to untether longer term rates before it moves aggressively to raise money market rates. But, we doubt the Fed will permit the yield curve to steepen sharply lest the frail recovery is choked off. Interestingly gold has tumbled as intermediate and long-term interest rates have climbed. The former suggests investors are less concerned about inflation while the yield spike implies the contrary. To say investors are conflicted is to be charitable. Clueless is perhaps more apt.

The recent spike in yields is a reflection of the market's concerns, worried about the end of the Bernanke tenure as chairman of the Federal Reserve. When his successor is appointed, we doubt there will be a sea change in policy. He or she will take the helm at a time fraught with risks. He/she will inherit an anemic, albeit growing economy, which is unlikely to expand fast enough to make a real contribution to improving household incomes. Unless the economic statistics quickly improve, a radical change is not in the cards.

We doubt this is the end of the bull run in bonds. We question even if it is the beginning of the end of the Fed's accommodative policy stance. It is perhaps the end of the beginning phase of a shift in expectations.


Notes on Sources, Methods and Definitions:

The Federal Open Market Committee (FOMC) is a sub-committee of the Federal Reserve Board. The FOMC meets at least eight times per annum to determine appropriate targets for selected money supply measures and baseline interest rates.

A key baseline rate managed by the FOMC is the federal funds (fed funds) rate. The fed funds rate is the rate member banks (of the Federal Reserve system) charge for overnight loans of excess reserves to other banks in a deficit reserve position. In this role, the fed funds rate is used as a barometer of the Federal Reserve's monetary policy. A low rate implies the Fed is willing to supply liquidity to the banking system; a high rate in contrast suggests the Fed is rationing liquidity to member institutions.

In an effort to improve the transparency of FOMC press releases, the committee simultaneously releases member expectations of key economic measures and policy variables. The accompanying charts are compiled from these member projections.

(Sources: Federal Reserve; FOMC; AIFS estimates.)


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