Yesterday the Federal Open Market Committee (FOMC) announced that it will initiate a new program of long-term Treasury purchases in January following the end of its “Operation Twist” program at the end of this year. The new purchase program will be conducted at an initial pace of $45bn (matching the size of Operation Twist), in line with market expectations.
Additionally, the FOMC announced that it will continue its current program of purchasing $40bn in MBS monthly, as well as maintaining its ongoing reinvestment of maturing assets into MBS. In January, the FOMC will also resume rolling over maturing Treasuries at auction (halted under Operation Twist as the FOMC was actively selling the short-end of the curve and allowing maturing Treasuries to roll-off the balance sheet).
The mix of Treasury purchases under the new program is distributed across a more balanced time-buckets compared with Operation Twist, which excludes the 4-6y sector.
The FOMC also removed the date-specific language from its forward rate guidance and replaced it with thresholds for unemployment and inflation.
Introducing thresholds is considered a more flexible approach and allows forward guidance to shift as the economic outlook evolves. The Committee expects that the federal funds rate will remain at an “exceptionally low” level “at least as long as” the unemployment rate remains above 6.5% and inflation one to two years out is projected to be no more than 0.5% above the FOMC’s 2% target, and inflation expectations remain anchored.
The Committee noted that it “views these thresholds as consistent with its earlier date-based guidance.” Finally, inserting the words “at least as long as” when describing the threshold for the unemployment rate stresses the import that these thresholds are not “triggers” for rate hikes, but rather are guidelines of when those discussions should begin. Moreover, the Committee stressed that it will consider other labor market indicators “in determining how long to maintain a highly accommodative stance of monetary policy”, which should satisfy those participants on the Committee who believe the unemployment rate should not be considered the sole indicator of labor market health.
One surprising aspect of the FOMC new interest rate guidance is that it links the interest rate decision to inflation over a relatively short period of time – one to two years forward. Inflation over short-periods can be volatile owing to fluctuations in commodity prices.
Let’s focus on the fact that the FOMC will now hold Fed Funds between zero and 0.25% until the jobless rate falls below 6.5%.
That’s a big deal as it makes two huge assumptions. The first is that the Fed is actually capable of influencing the jobless rate that far down. The second is that the Fed has thrown its dual mandate out of the window, and specifically that it’s abandoned inflation for a while.
So the big deal here is that Bernanke is really out on a limb with his view that Non Accelerating Inflation Rate of Unemployment (NAIRU) is down at 6.5% and that there’s been no structural shift that’s put it more like 7.5% (ie close to where the rate currently stands).
The market isn’t convinced. The long bond always faced the threat of selling off from the simple fact that positioning was so strong. The latest CFTC showed the net spec at just under 57k lots – the highest level since mid December 2007. The upturn driven by longs (rather than a decrease in shorts). But under the risk conditions that the Fed is now willing to accept, the market’s first reaction was to exit the long end and turn to real assets. Equities are the real beneficiaries from all this. In many ways that shouldn’t be a huge surprise.
In other words, the feel good factor. The equity market views this as an early Christmas present – even if the macro element of the policy doesn’t work so well (ie it doesn’t generate the kind of growth hoped for), from a trading perspective, investors are incentivised across to the equity market. The Fed took another leap of faith here then – it assumed that pricing power has returned to the US corporate sector (and the retail sector) and that the economy can handle the results of that. Is this assumption correct?
If it’s wrong and the push towards 6.5% jobless generates inflation that can’t be passed on but must be absorbed, and the threat to earnings is considerable.
The Fed has opened itself to a new internal debate. The QE program is now open ended and running at $45 bln Treasuries and $40 bln MBS. To what extent will the hawks push for that to be tapered. After all, as the jobless rate falls towards its target, it could be argued that conditions are incrementally ‘less worse’ than they are at present. That wraps back in with the previous point. As improvements in the labour market come, but the Fed holds to the purchase pace, the effective extent of stimulant rises (in relative terms), and so the inflationary pressure increases.
What all this mean is that: 3% inflation is a price worth paying to achieve growth. That’s a problem for Treasury yields which out as far as the 30-year is trading well below 3%. In other words, the risk is much as it’s been in UK Gilts – that a permanent overshoot causes year-on-year negative real yield returns.
The other issue surrounding an unemployment target is that the unemployment rate isn’t necessarily reflective of the true state of affairs. Fed members have stated in the past that what they’d prefer to see is month-in, month-out NFP gains of 150k plus. The rate itself being subject to changes in the workforce and participation. The Fed works round this problem by taking a range of indicators into account.
What does it mean in term of Asset Allocations?
The Fed is going to own the long end, so to that extent the market needs to consider how valuable the natural bid is and the extent to which the curve deserves to be steeper. Given the 6.5% target, one must also view the Fed’s decision as one in which it wants to be absolutely certain the recovery is fully entrenched before there’s any take back. This is the reason for moving away from the date based version. It was unfortunate the Fed wasn’t able to communicate the real intent of the date system – it was never a fixed point but rather an estimate of when data will be strong enough to warrant tighter policy. The Fed has just drilled down a bit to make it easier to read – what it means by ‘when data is strong enough’translates to when jobless is 6.5%.
What comes next? There’s more to come from the Fed, but the conclusion must be that it has the health of corporate America on an equal footing as the housing market now.
As we said in our previous posts the housing market has offered support to the US economy but the question we asked few months ago: will the Housing market alone be able to bring Corporate America back on the growth path, remains unanswered.