After every research shop on Wall Street put out estimates of whether a little bit of taper or a lot of taper would be announced at this week's Fed meeting, it was all for naught. Ben Bernanke & co. surprised everyone by announcing that the LSAP (Large Scale Asset Purchases) would continue as scheduled at $85 billion per month.
The Fed conceded in a series of papers, one from the San Francisco Federal Reserve, that the LSAP or Quantitative Easing (QE) does little for economic growth. We have been on board with this line of thinking for over three years, and again will cite Richard Koo, Nomura's Chief economist and expert on Japan's QE and policy over the last 20 years, that QE is essentially a "non-event." Meaning that it can influence interest rates (lower) with its effect on market participants, which has some benefit for households and corporations refinancing debt, but it will not spark an increase in credit levels when the private sector prefers to lower its debt burden, for now at least. Below is the percentage of household debt to GDP, which peaked at 94% and still falling, now at 77%.
This was the second September in a row that the Fed surprised markets with easier monetary policy. Last year it was Quantitative Easing 3, this year it was slowing LSAP, to any extent. In between was when the Fed introduced 'Forward Guidance' and thresholds in which policy changes may occur – 6.5% unemployment and 2.5% inflation. Yet when pressed, the Fed essentially said "we never really said we would HAVE to do something as these thresholds were hit, but we might (depending on the data)." And with the unemployment rate coming down because of okay hiring and as a matter of demographics, with baby boomers retiring each month, Fed officials' speeches the last few months hinted that the unemployment rate may not actually be a great measure of the labor market's strength.
The Fed doesn't like mortgage rates this high or the 10-year at 3% because it slowed the pace of new home sales, a key contributor to growth of late.
So with its words the Federal Reserve exerted influence on the expectations of future interest rate hikes, sending yields lower and bond prices higher. The chart below shows how expectations changed over the last five months. The Fed showed it does not want to let higher interest rates derail the recovery or pace of employment gains. Yet because so many regional Fed presidents alluded to 'tapering asset purchases' since May, many traders were caught in the wrong position being short bonds, betting interest rates would continue rising, hence the surprising news and large reaction across capital markets on Wednesday.
What's next? Lower real interest rates are a possibility in the near term. In the last episode of relatively 'easier' monetary policy, investors got the inflationary signal and a decline in the US dollar began. This increased the use of the U.S. dollar as a funding currency to purchase other assets abroad – emerging market currencies, foreign stock, etc.
What could bring another leg higher in interest rates in the medium-term, perhaps a similar narrative to last time? Talk from the Fed that they would like to end the LSAP... or slow down at least. Interestingly at Ben Bernanke's conference, he used the word 'tightening' instead of 'taper,' which is another clue about the direction the Fed is going. The other clue will be the long-end of the treasury curve, in which bond traders will show them it is time to move as inflationary expectations increase. And though it is just at the margin, inflationary pressures are building in labor markets in the U.S. – which correlates with the 10-year Treasury yield.
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