Wednesday, September 18, 2013

No Tapering...For Now

Market participants were quite surprised at the FOMC's decision to not taper its asset purchase program today. The consensus among many analysts and economists was for the FOMC to taper or reduce the size of its asset purchase program in the range of $10-$15 billion. The reaction to the announcement was quite volatile. The S&P500 rallied to an all time high of 1725, the 10-year treasury yield decrease 15 basis points (bps) to 2.70%,  precious metals rallied and the U.S. Dollar depreciated against the majors. 

Why Not Taper?

During Bernanke's press conference, there was a question phased as "Why not taper now given that the Fed has already signaled to the market that it will taper in September?". The Fed Chairman's answer was simple: the reduction of QE is heavily data dependent and financial conditions have tighten considerably to pose a risk to the economic recovery. Bernanke reiterated his stance that there is no "pre-set course" on ending the asset purchase program (QE3) and market participants were wrong to bet on a September taper. The Fed will consider reducing QE in the "coming meetings" depending on incoming data. Nonetheless, Bernanke's tone in the press conference was more cautious and suggest that the Fed may wait longer before tapering QE; the following statement from the FOMC illustrates this point: "...the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases"

Bernanke clearly explained that the labour market must improve "substantially" and the outlook for the labour market must be equally solid to justify a reduction of QE. The labour market improved since last September, but the improvement was not  "substantial".
  • The 6 month average non-farm payrolls did improve from 140K last August to the 155K currently. Many FOMC members stated in their public speeches that a run-rate of 200K or above defines a solid labour market. Because the rolling 6-month average payroll number is still below the 200K level, a September taper does make sense especially due to the Fed's mandate of maximum employment
  • The unemployment rate decreased from 8.1% in August 2012 to 7.3% currently. Although the 0.8% reduction in unemployment rate is encouraging, part of the decrease is attributable to the 0.3% decrease in the labour participation rate during the same period, which is definitely not positive. As Bernanke stated in the press conference, the 0.8% decrease should be partially discounted because it ignores decline in the participation rate 
There are also other reasons, as outlined below, that explain why the Fed did not taper:
  • The recent spike in interest rates was a major concern as outlined in today's FOMC statement "the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market". It was obvious that FOMC members realize that market participants perceived tapering as tightening. Given that interest rates have increased significantly since June, FOMC members wanted to let interest rates fall slightly in order to stimulate economic activity, especially in the housing sector. i.e. recent weekly mortgage applications have been decreasing at double digit percentage rates. This is attributable to the 120 bps rise in the 30-year mortgage rate from 3.5% to 4.7% in less than 3 months
  • The recent run-up in rates has partially alleviated the Fed's concern about financial stability. Higher interest rates and speculation regarding a September taper helped to reduce the excessive levered positions taken by speculators. With less concerns regarding financial stability, the Fed decided to continue QE as risks to the recovery still remains
  • Fiscal problems, such as the potential debt ceiling debate later this month and a possibility of a government shutdown, may slow the recovery. A repeat of 2011 would be disastrous for the financial markets and the Fed is just being cautious ahead of the negotiations 

In the final analysis, all of the points above explain why the Fed decided to keep the size of its asset purchase program at $85 billion and did not taper QE. Also, it is interesting to note that FOMC members lowered their GDP forecast for 2013 to 2.0-2.3% from 2.3%-2.6%. 

When Will the Fed Taper?

Don't count on the 7.0% and 6.5% thresholds:

Many analysts thought Bernanke was giving specific guidance when he indicated that the QE program will end by the time the unemployment rate hit 7.0% and a first hike will occur when the unemployment rate hit 6.5%. Because the Fed chairman uses words like "depends", "subject to", and "data dependent" when explaining Fed policy, investors should rely less on the numbers provided and more on the chairman's qualitative descriptions. He made it clear in today's press conference that the numbers provided were used as illustrations to describe potential exit strategies. Also, the 7.0% and 6.5% are used as thresholds, not as triggers. QE does not necessarily end when the unemployment rate drops below 7.0%. By the same token, a rate hike is not automatically considered if the unemployment rate drops below 6.5%. Investors must remember that the Fed has a dual mandate of maximum employment and price stability. Whether QE is a good policy tool or not is debatable, but FOMC members are simply doing their job by promoting maximum employment when they decided to not taper today. 

The Fed will taper when the labour market has improved "substantially":

As discussed above, the Fed will taper QE when the labour market improve substantially. A substantial improvement can be defined when all the conditions below are satisfied:
  • When the 6 month average payrolls number is near or above the 200K level 
  • Unemployment is below 7% AND the labour participation rate shows some improvement from current levels
  • Wage growth is at or above the current 2% level
  • Improvement in other labour market statistics: lower longer term unemployment, lower number of discouraged workers and higher private payrolls

The actual timing is difficult to ascertain but the Fed will eventually taper: 

In my opinion, predicting when the Fed will taper is a pure gamble. Because the FOMC hinted at the possibility of tapering in the "coming meetings" in today's statement, investors should expect a taper announcement either in the October or December meeting depending on the incoming economic data. Investors are making a mistake if they think the Fed will continue its easy monetary policy. Generally, the economy is on a better footing compared to last year, so less monetary stimulus is justified. The Fed needs to communicate clearly to the market on how it will reduce QE over time when it begins to taper QE. Overreactions in the financial markets, such as the rate shock in June, can spill over to the real economy and damage the underlying recovery. 

Implication for Investments:

Today's Fed announcement did not change my long term investment outlook. Investors are facing a rising interest rate environment in the long run and chasing after yields is a bad strategy. Short to intermediate term bonds are better choices than long term bonds, although the long-end of the curve may outperform in the short term. As for equities, valuations are no longer attractive and caution is warranted given that lower interest rate (the driver of lower discount rates) won't be around forever. However, equities are not terribly overpriced either, so betting against stocks is also not a good strategy. I am maintaining all my long equity positions, although I may sell into large rallies in the upcoming months. 

The energy and materials sectors will benefit from today's Fed announcement and will outperform in the short term. Because these two sectors were the laggard this year, investors may benefit from overweight energy and materials stocks relatively to other sectors. Nonetheless, individual stock selection is important given that not all stocks in the energy or materials sectors are attractive.  

There will always be opportunities to take advantage of one-sided expectations. As described in my prior posts, the 10-year treasury with a 3% yield is too high because higher rates will eventually cripple the recovery. After today's rate announcement, the yield decreased to 2.7%. If the yield drops below 2.3% in the upcoming month, a short rates trade may look attractive. The 2.3% was the yield before Bernanke laid out the framework for tapering QE in the June 19th FOMC press conference. The Fed will taper eventually so any large drop in rates, especially within a short time period, provides a good opportunity to short rates.

All in all, investors should remember this: financial assets (stocks or rates) don't grow to the sky, nor do they fall to the floor. 

Appendix: FOMC policy statement [1], bolded sentences are important.

Information received since the Federal Open Market Committee met in July suggests that economic activity has been expanding at a moderate pace. Some indicators of labor market conditions have shown further improvement in recent months, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has been strengthening, but mortgage rates have risen further and fiscal policy is restraining economic growth. Apart from fluctuations due to changes in energy prices, inflation has been running below the Committee's longer-run objective, but longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic growth will pick up from its recent pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate. The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished, on net, since last fall, but the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market. The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term.

Taking into account the extent of federal fiscal retrenchment, the Committee sees the improvement in economic activity and labor market conditions since it began its asset purchase program a year ago as consistent with growing underlying strength in the broader economy. However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases. Accordingly, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee's dual mandate.

The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. In judging when to moderate the pace of asset purchases, the Committee will, at its coming meetings, assess whether incoming information continues to support the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective. 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.

To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Charles L. Evans; Jerome H. Powell; Eric S. Rosengren; Jeremy C. Stein; Daniel K. Tarullo; and Janet L. Yellen. Voting against the action was Esther L. George, who was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations

[1] FOMC Statement
[2] FOMC Projects
[3] FOMC Press Conference

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