The US Federal Reserve delivered a shock to financial markets last night by not announcing tapering of its quantitative easing programme, with expectations centred on a $10bn to $15bn reduction to the $85bn per month asset purchases. In the committee‟s words “...the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases.”
I certainly found it a shock and had been public in my 98% probability of tapering being announced in September. My confidence was based on a continued rhetoric from Federal Reserve members who had established a firm, but not quite 100%, market consensus that we should all prepare for a reduction in purchasing levels. Furthermore the Federal Reserve had an academic paper that questioned the efficacy of quantitative easing and its limited impact on the real economy.
Although I was incorrectly confident about the exact timing of the tapering, I was far less sure about how to make money for our Funds out of it. Fortunately in our Kames Strategic Bond Funds we believed that given the pace and size of the rates correction, coupled with steep yield curves, a large part of the potential tapering was reflected in market prices. Although the Funds are underweight interest rate risk they still retain plenty of room to shorten duration further and given the rally in US Treasuries we have sold half a year‟s worth of US duration for both the Kames Strategic Bond Fund and Kames Strategic Global Bond Fund this morning.
Reasons for delaying tapering
There are four reasons that the Federal Open Market Committee (FOMC) may have delayed tapering; clearly these are highly inter-related to each other.
Mixed economic data
The Federal Reserve has revised down its real GDP forecasts for 2014 from “3.0 to 3.5” to “2.9 to 3.1” with the top end of the range bearing the brunt of the downgrade. I would argue that all this has injected some much needed conservatism into the numbers. Forecasts for 2013 now stand at “2.0 to 2.3”, which in my opinion is a credible and achievable rate for this year. The central bank continues to caution against solely focusing on the unemployment number and refer to “additional measures of labor market conditions” which predominantly reflect the level of the labour force participation in the economy.
Subdued inflation
With inflation being low, nominal growth will remain comparatively moribund in nature. Forecasts for the PCE (personal consumption expenditure) price index for 2013 are “1.1 to 1.2” and “1.3 to 1.8” for 2014. This nominal growth outlook in no way denies that the US economy has momentum, but does show that with low inflation the FOMC can risk keeping stimulus expanding for longer and it will fight against factors that might derail the ongoing recovery.
Increased mortgage rates
The Federal Reserve is walking the fine line between discouraging financial market excesses and not creating too much market-induced monetary tightening. I believe that the FOMC is referring to the mortgage market and its impact on the housing market, and associated economic activity, when it says “...the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market.”
Chart: US 30-year mortgage rates (source: Kames Capital, Bloomberg, Bankrate.com)
The US is once again close to breaching its debt ceiling; the political noise around this could well affect consumer confidence. More importantly any federal shutdown will have a meaningful, albeit probably transitory, impact on unemployment and activity levels. The debt ceiling point is the least influential of the four but waiting a few months to start cutting back on QE is the sole prerogative of the FOMC.
Implications of FOMC intransigence
Short term
Last night delivered the second most bullish of any realistic scenarios to markets (the most bullish would have been a small taper coupled with a lowering in the unemployment target to, say, 6%). Clearly the market reaction has been „risk on‟ with a small salute to the Fed for encouraging carry trades once more having leant against them since 22 May. In US Treasuries there has been a savage short squeeze with 10-year yields falling from 2.85% to 2.70%. As mentioned above we have taken this opportunity to reduce duration by half a year in the US. Our Strategic Bond Funds still have a positive duration contribution but are in all probability now short relative to peers and indices. Credit markets have rallied and we do not yet think it is time to oppose this given the strong economic backdrop, however should any rally continue meaningfully we will take the opportunity to rotate out of some of the Funds‟ lower conviction holdings.
Medium term
In the medium term, representing the next few months and quarters, the Fed is only delaying what I believe is inevitable. Effectively the US monetary cycle changed on 22 May even with the continued $85bn purchases. The trend in US market interest rates is up; the delay to tapering affects the timing but not the direction. In the Fed‟s own words “...Asset purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on the Committee's economic outlook as well as its assessment of the likely efficacy and costs of such purchases.”
Long term
Having spent so long priming the market for a policy change, to fail to deliver has damaged the Fed‟s credibility. There is a conspiracy theory that this leaves room for the Fed Chairman heir apparent, Janet Yellen, to be the one that announces tapering and thereby reduce her dovish reputation. Frankly I do not believe this conspiracy theory and merely think that the Fed continues to be more tolerant of the risk of a policy overshoot in its battle to keep the economy on track. Until an inflationary spiral is created, which normally requires an increase in wage inflation to create the self-fulfilling feedback loop, monetary policy will remain stimulatory. We can debate how quickly quantitative easing finishes, but it is incredibly unlikely that interest rates will go up before 2015. Furthermore peak interest rates in this cycle are likely to be lower than prior cycles given the overhang of debt that still exists.
