The Fed postponed the tapering of its quantitative easing (QE) program because of lackluster economic growth and lingering doubts about the sustainability of lower unemployment. Fed purchases of mortgages and Treasuries remain at $85 billion per month. A token taper of $5 to $10 billion is possible in December, but don’t expect serious adjustments till 2014. As Fed Chairman Ben Bernanke mentioned, fiscal policy, not monetary policy, remains the main threat to the US economy.

 

The Federal Open Market Committee (FOMC) decided not to taper QE in spite of an overwhelming market consensus to the contrary. Lackluster GDP growth and genuine weakness in the labor-market recovery prompted a taper re-think. Bernanke restated that the Fed is concerned about the drop in the participation rate (PR) and that the official unemployment rate (7.3%) currently understates the true level of unemployment. Speculation about tapering has tightened financial conditions since the spring, which might dampen credit growth and housing activity. This has created risks, but has not materially altered positive underlying growth prospects. With the economy set to remain sluggish during the autumn before strengthening markedly next year, a serious adjustment in QE seems unlikely before 2014. The Fed might then wind down QE relatively quickly.

 

Investors are understandably pre-occupied with US monetary-policy risks. To avoid unsettling markets again, the Fed will need to strengthen its forward guidance on interest rates, however this will be challenging until investors know who Bernanke’s successor will be. Either way, the market will remain focused on the outlook for Fed asset purchases over the next 9 months. Ben Bernanke has stated that the FOMC plans to end QE by mid-2014, but he has said nothing about the likely pace of tapering during this period: there is no pre-set course. So how the economy evolves will be critical. Expect growth to remain sluggish for the rest of 2013 before strengthening sharply through 2014 on the assumption that the fiscal squeeze will fade. While this does not exclude a token – say $10bn – taper in December, a meaningful adjustment is unlikely before 2014. At that point, if growth is strong, the Fed could complete tapering fairly quickly. Nonetheless, investors should not forget about policy risks on the fiscal side, with Congress set for another battle over the debt ceiling, sequestration issues, and continuing clashes regarding healthcare/Obama-care.

 

If the Fed can keep mortgage rates around current levels, they will not derail the economy. First, housing affordability is still good by historical standards – even after the recent rise in bond yields. Second, there is pent up demand for housing, especially if the jobs market improves. Third, almost a third of US households haven’t been able to refinance their mortgages in recent years because they have been in negative equity (with homes worth less than the value of their mortgage). However, home prices have been recovering and, if this continues, many of these households might soon be able to refinance at rates well below what they are paying.

 

Ben Bernanke’s term as Fed chairman ends on January 31, 2014; uncertainty over who will replace him has not helped the Fed anchor market expectations. Mr. Bernanke has established various ‘thresholds’ for monetary policy. He has said the FOMC expects to end QE with the unemployment rate at around 7% and that the committee will not consider raising interest rates until unemployment reaches 6.5%. Given it is already at 7.3%, there is a strong case for reducing these jobless thresholds further. The important lesson is simple; if you want to forecast the Fed, base it on how you see the US economy evolving.

 

Taxable bonds, municipals and stocks were down about -1% to -3% in August. Volatility has continued, but the Fed has again reinforced the floor under the markets. The backup in interest rates has made municipal yields look especially attractive.

 

 

Michael Ashley Schulman, CFA

Managing Director