Taper Talk to Interest Rate Hike Hearsay

Aurum Weekly Access - 12/19/13
By Michael McKeown, CFA, CPA - Director of Research

If your ear drums have not blown out from the overuse of the word 'taper' in financial media, then you will be happy to know the Fed announced it will be slowing its asset purchases by $10 billion next month.  We mentioned this back in May in our piece "Closer to the Q-End?", highlighting the Fed's putting markets on notice and before interest rates spiked.   Lately many folks guessed whether taper will come this month, in three months, or six months, we began to think about when and how an interest rate hiking cycle could come about.

The Fed governor speeches of late pledged to hold interest rates lower for an extended period, but recent meetings indicated the Fed is data dependent on jobs and inflation numbers for its decision making process.  This really confused the bond market because if the Fed is allowing data to guide the Fed Funds policy, then without perfect foresight of future data, they cannot truly know interest rates will stay low for an extended period.  Since forecasting of economic data is typically a fool's errand, then forecasting the Fed Funds rate might be nearly impossible.  This is especially true since some of the signposts from history are not being followed. 

Below are the average hourly earnings of private employees (blue).  In the three previous interest rate hiking cycles, this data bottomed at the same time the Fed began raising interest rates (red).  This time around though, the data rose steadily for the past year, yet no interest rate hikes occurred. 


Below are the average hourly earnings of private employees (blue).  In the three previous interest rate hiking cycles, this data bottomed at the same time the Fed began raising interest rates (red).  This time around though, the data rose steadily for the past year, yet no interest rate hikes occurred.

Still, just because the Fed does not hike rates, it does not mean interest rates cannot rise.  Take for example the summer, when the 10-year Treasury bottomed at 1.6% in May and quickly hit 3%. The Fed does not control the curve, it can influence the shape, but markets ultimately will decide where it goes, especially as the Large Scale Asset Purchases (aka LSAP, now known as QE) wind down.

Kevin Ferry, frequent guest on CNBC, fixed income trader, and popular market commentator showed his model for neutral Fed policy as 12-month Libor minus 0.60%.  As one can see, it tends to be a good indicator of where the Fed Funds rate should be.  With LIBOR on the floor currently at 0.57%, the Fed 0% target for Fed Funds is just about right.  In other words, this contradicts the above chart and says there should not be any interest rate hikes in the near term as the blue line leads the red line in hiking cycles.

The Kevin Ferry Rule (12-Month Libor less 0.6% = neutral Fed Funds Rate)


Still it seems participants betting on rates across the yield curve staying lower for longer are a few years behind.  The market already thinks rates will rise over the next 12 month as the 10-year Treasury is at 2.9% and the forward curve puts it at about 3.3% at the end of 2014.  The question now is whether this is the right expectation or will it move up faster or slower?  In addition, how will the short to intermediate duration part of fixed income react over the next few months, especially if growth accelerates?

Going into 2013, no one thought the Fed would take their foot off the gas.  Now that they have, everyone seems to buy the following chart.  It shows the consensus among Fed governors that an interest rate hiking cycle will commence in 2015.  The median Fed governors thinks the Fed Funds rate will be about 0.5% higher at the end of 2015 at 0.75%, compared to the current 0-0.25% target rate.


Source: Federal Reserve

The risk is that the timeline gets moved ahead even more, but this could be great news for the economy if growth picks up. The story of 2014 could be the public conversation of when and how fast the Fed raises interest rates this cycle.  This would increase the cost of credit for businesses and individuals while negatively impacting the principal of bond portfolios exposed to the short to intermediate portion of the curve.


Important Disclosures 
This material is based on public information as of the specified date, and may be stale thereafter. We make no representation or warranty with respect to the accuracy or completeness of this material. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Aurum Wealth Management Group and/or Aurum Advisory Services does not represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein. This material should not be viewed as advice or recommendations with respect to asset allocation, any particular investment, or any tax advice.

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