Economic & Market Review - September 2013

by Gavin Graham, Chief Strategy Officer September 29, 2013
Notice: This newsletter is intended as a general financial market outlook, and should not be relied on as investment advice.

On September 18th, the US Federal Reserve (the Fed) made the decision or rather, the non-decision, not to reduce the $85 billion worth of Treasury and Mortgage-backed bonds that they are currently buying each month, known as Quantitative Easing (QE). The markets were rattled from the shock of the announcement. Most investors felt that retiring Fed Chairman Ben Bernanke had given clear indications in his speeches in May that the Fed would begin reducing the amount of government debt it was purchasing (described as “tapering”) before the end of the year, probably by $10-15 billion a month. On the announcement, the stock market sold off initially, while the Treasury bond market soared.

Of course, even the reduced amount of purchases would still have left the Fed buying between $840 billion and $900 billion of US government debt in 2014. Given that the Federal deficit for the 2012-13 fiscal year, which ends on September 30th, 2013, is estimated to only amount to $570 billion or so, essentially the Fed would be funding the entire government deficit, with some left over to purchase bonds held by the private sector. Instead the Fed will be on track to purchase over $1 trillion worth of government debt for the second year in a row.

The reason for the Fed's decision to begin tapering was the revival of the US economy. In the first half of 2013, US Gross Domestic Product (GDP) accelerated to 1.9% (an annualized basis) in the second quarter from 1.1% in the first quarter, and the expectation at the Fed was that this rise in growth would continue in the second half as the effects of the government sequestration at the beginning of 2013 fell away. Job growth averaged 199,000 per month in the first half to May, and the unemployment rate fell to 7.3%.

The reason for the Fed's decision not to taper seems perfectly plain; in the three months since Mr Bernanke indicated that tapering was likely to start, the yields on 5, 10 and 30 year US Treasury bonds shot up by over 1%, to almost 3% for the benchmark 10 year bond. The losses suffered by investors in the long end of the bond market were the greatest in almost twenty years, since Mr Bernanke's predecessor Alan Greenspan unexpectedly raised interest rates in early 1994, setting off a rout in the bond market.

Meanwhile, job growth fell to 148,000 in just one month and the unemployment rate only remained at 7.3% due to numerous workers leaving the workforce due to poor prospects for jobs. Inflation has remained well below the Fed's target of 2% for the last eighteen months, despite the massive injections of liquidity provided by the QE programme, so the Fed governors, including Mr Bernanke's likely successor, Janet Yellen, evidently felt it was prudent to continue QE at its present rate until there were definite signs that the recovery had really taken hold.

Unfortunately, in doing so, they have sacrificed the credibility of the Fed. If the central bank is not prepared to moderately reduce the massive amount of stimulus it is still providing five years after the bankruptcy of Lehman Brothers in September 2008 plunged the world financial markets into the biggest bear market since the Great Depression of the 1930s, then investors are entitled to wonder when it ever will.

Mr Bernanke set explicit targets when he introduced the original version of QE in 2012, saying that the Fed would not begin to tighten (i.e. raise interest rates) until unemployment was down to 6.5% and inflation was over 2.5%. He didn't specify whether the Fed would tighten if one of these targets was hit, or whether both needed to be met, but there was a clear target, which gave the markets comfort.

One of the reasons that the sell-off in the bond markets was so intense after Mr Bernanke's May statements was that investors had become so accustomed to very low interest rates and massive stimulus through QE that even the first hint of a removal of the latter was enough to cause panic. Effectively, by over-reacting to the likelihood of tapering, the bond market caused a tightening by itself, as mortgage rates are priced off the yields of 10 and 30-year Treasury bonds. One of the consequences was a decline in mortgage volumes which led to major US banks cutting staff in their mortgage department which contributed to lower job growth. The ripple effect was felt on house and building purchases and construction activity.

However, all good things must come to an end and even after the Fed backtracked on introducing tapering in September's meeting, the market knows that it will arrive sometime in the next twelve to eighteen months. Meanwhile, Treasury bond yields are still 1% higher than they were a year ago and holders of the Bloomberg US Treasury Bond Index have suffered losses of 2.6% over the last year, after taking the interest they have received into account, the second worst year in the last two decades.

In retrospect, Mr Bernanke's successor may come to wish that the Fed had followed through on its May decision and begun the process of removing stimulus, as when tapering does begin, it is likely to have to occur much more rapidly and in more difficult circumstances. Holders of long-dated US Treasuries and mortgage backed bonds have received a warning of what will happen to bond prices when yields do start to rise and should reduce their holdings accordingly.

Source: Bloomberg as of September 30th, 2013