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Interest Rates

The Truth about the Fed’s Great Taper

By Elliott H. Gue, on Oct. 1, 2013

In the late 1990s, investors and pundits chattered incessantly about “New Economy” stocks and the potential for the Internet to change the way the world conducts business. At the time, shares of Ralston Purina–a company that makes pet food–fetched 2 times sales, while shares of Pets.com, a now-defunct online purveyor of pet products, traded at 20 times sales.

After the collapse of innumerable Internet companies, “bubble” became one of the most overused terms in the financial media. Every time a sector or industry outperformed, a talking head would appear on television warning that the group was in a bubble and that the impending collapse would decimate investors’ portfolios.

One of last year’s watchwords was “Grexit,” a term that conveyed the potential for Greece’s exit from the eurozone to spark another financial crisis. Of course, this catchy neologism doesn’t tell investors that Greece was unlikely to leave the EU or that the country’s US$250 billion in gross domestic product is relatively insignificant in the context of the eurozone’s US$16.5 trillion economy. As American novelist Mark Twain once quipped, “Never let the truth stand in the way of a good story, unless you can’t think of anything better.”

This summer’s buzzword of choice: “taper,” shorthand for the Federal Reserve’s plan to wind down quantitative easing (QE). When the dog days of summer hit and market volume contracted, financial commentators relied on the Fed’s Great Taper to explain every up and down move in the S&P 500.

Meanwhile, the media dissected every look or offhand comment from a Fed official–regardless of whether he or she is a voting member of the Federal Open Market Committee–to divine when the Federal Reserve would begin to phase out its third round of quantitative easing.

Like most investment fads and sophistic one-size-fits-all explanations of complex macroeconomic developments, the hype surrounding the Great Taper led to bad decisions and lost opportunities on the part of skittish investors.  

What is QE?

Quantitative easing occurs when the Federal Reserve buys bonds to push down longer-term interest rates and reduce borrowing costs. Unlike most investors, the Fed doesn’t need actual money to purchase bonds and other assets; the central bank effectively creates money by crediting the accounts of financial institutions from which it purchases bonds. After all, the US dollar isn’t backed by anything tangible–it’s just numbers on a screen.

When the Federal Reserve buys bonds from a bank, these purchases tend to bolster the price of the assets involved. Securities’ prices and yields move in opposite directions: For example, when bond prices rally, bond yields decline, lowering borrowing costs and, theoretically, spurring lending and economic growth. Quantitative easing also adds cash to the banking system–the Fed buys bonds using money it creates out of thin air–in the hope that these financial institutions will lend this capital to businesses and individuals.

Source: Bloomberg

Total assets on the Fed’s balance sheet have ballooned to $3.722 trillion from $894 billion at the end of 2007–a more than fourfold increase in a little more than five years.

Since late 2012, the US central bank has purchased about $85 billion worth of bonds each month, equivalent to about $1 trillion each year. Several rounds of quantitative easing are visible in this graph. Although the Fed pressed pause on its bond buying in 2009, 2010 and 2011, the central bank ultimately resumed this program each time US economic growth faltered.

Some commentators dubbed the most recent round of quantitative easing, announced in late 2012, as QE Infinity because the Fed didn’t announce a cumulative target for bond purchases or a specific time frame. Instead, the Fed indicated that the central bank would purchase $85 billion worth of bonds each month, until the economy and labor markets show substantial improvement.

The Federal Reserve’s balance sheet now includes about $2 trillion worth of US Treasury securities and $1.33 trillion in mortgage-backed securities (MBS).

Source: Bloomberg

By purchasing MBS securities–bonds backed by interest and principal payments on a pool of mortgages–the Fed directly influences interest rates on home mortgages. 

3 Myths about the Taper

Myth No. 1: Although the word taper implies a gradual winding down, some investors mistakenly believe that the Federal Reserve’s plan to end quantitative easing means that the central bank will halt bond purchases immediately.

Fed Chairman Ben Bernanke addressed this misconception during a June 19 press conference:

…the Committee has been purchasing $40 billion per month in agency mortgage-backed securities and $45 billion per month in Treasury securities.

When our program of asset purchases was initiated last September, the Committee stated the goal of promoting a substantial improvement in the outlook for the labor market in the context of price stability and noted it would also be taking appropriate account of the efficacy and costs of the program.

Today the Committee made no changes to the purchase program.

Although the Committee left the pace of purchases unchanged at today’s meeting, it has stated that it may vary the pace of purchases as economic conditions evolve.

Any such change would reflect the incoming data and their implications for the outlook, as well as the cumulative progress made toward the Committee’s objectives since the program began in September.

Going forward, the economic outcomes that the Committee sees as most likely involve continuing gains in labor markets, supported by moderate growth that picks up over the next several quarters as the near – term restraint from fiscal policy and other headwinds diminishes.

We also see inflation moving back toward our 2 percent objective over time.

If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year. And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear.

Once again, Chairman Bernanke emphasizes that the Federal Reserve will gradually reduce the pace of its bond purchases and that the timing of this process will hinge on incoming economic data.

As we explained in Don’t Fight the Fed, Listen to It, the overly optimistic outlook for US economic growth outlined at the FOMC’s June meeting prompted us to predict that the central bank would delay its plans to taper quantitative easing.

Myth No. 2: The Federal Reserve’s commitment to tapering quantitative easing means that the central bank will shrink the size of its balance sheet.

In a June 19 press release, Fed Chairman Ben Bernanke likewise sought to correct this misconception:

It’s also worth noting here that, even if a modest reduction in the pace of asset purchases occurs, we would not be shrinking the Federal Reserve’s portfolio of securities, but only slowing the pace at which we are adding to the portfolio while continuing to reinvest principal payments and proceeds from maturing holdings as well.

These large and growing holdings will continue to put downward pressure on longer-term interest rates.

To use the analogy of driving an automobile, any slowing in the pace of purchases will be akin to letting up a bit on the gas pedal as the car picks up speed, not to beginning to apply the brakes.

Although the central bank eventually will stop purchasing bonds, investors shouldn’t equate the end of quantitative easing with a contraction in the Fed’s balance sheet. The central bank will continue to reinvest interest payments and principal repayments from maturing bonds into new bonds.

Given the size of the Fed’s bond portfolio, this policy still involves bond purchases, and, as Chairman Bernanke makes clear, these “large and growing holdings” would continue to exert downward pressure on interest rates.

Myth No. 3: The Fed’s plan to taper quantitative easing involves hiking interest rates.

Again, we refer to Chairman Ben Bernanke’s actual comments during a June 19 press conference:

I will close by drawing again the important distinction between the Committee’s decisions about adjusting the pace of asset purchases and its forward guidance regarding the target for the federal funds rate.

As I mentioned, the current level of the federal funds rate target is likely to remain appropriate for a considerable period after asset purchases are concluded.

To return to the driving analogy, if the incoming data support the view that the economy is able to sustain a reasonable cruising speed, we will ease the pressure on the accelerator by gradually reducing the pace of purchases.

However, any need to consider applying the brakes by raising short-term rates is still far in the future.

In any case, no matter how conditions may evolve, the Federal Reserve remains committed to fostering substantial improvement in the outlook for the labor market in a context of price stability.

The consensus among Fed officials is that the central bank won’t need to raise interest rates until 2015 or later. In this excerpt, Chairman Bernanke makes it abundantly clear that the decision to taper and the decision to hike rates are independent of one another. 

No Taper, No Surprise

Chairman Bernanke and other Fed officials repeatedly have indicated that the decision to taper quantitative easing hinges on incoming economic. Despite the media’s fondness for presenting the Great Taper as an impending threat, we’ve long argued that the US central bank would likely wait until at least December to curtail its bond purchases.

When the Federal Reserve on Sept. 18 announced that bond purchases would continue as usual, the financial media responded with shock–some pundits even went so far as to suggest that the central bank had misled the markets.

However, the Fed’s actions have been entirely consistent with its public statements; ever since May, Chairman Benanke has emphasized that any move to begin phasing out quantitative easing would hinge on economic data. Whether you believe the decision was correct or not, the Fed could not have been any clearer as to its intentions.

To hammer this point home, Chairman Bernanke updated the Fed’s take on the US economy during a Sept. 18 press conference:

In the Committee’s assessment, the downside risks to growth have diminished, on net, over the past year, reflecting, among other factors, somewhat better economic and financial conditions in Europe and increased confidence on the part of households and firms in the staying power of the U.S. recovery.

However, the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and the labor market.

In addition, federal fiscal policy continues to be an important restraint on growth and a source of downside risk.

Apart from some fluctuations due primarily to changes in oil prices, inflation has continued to run below the Committee’s 2 percent longer-term objective. The Committee recognizes that inflation persistently below its objective could pose risks to economic.

In this except, Chairman Bernanke notes that the pace of improvement in the US labor market has slowed somewhat since spring. Most investors are likely aware that growth in nonfarm payrolls, which averaged 212,000 per month from January to May, subsequently dipped to a mean of 150,000 per month.

Moreover, the Fed’s preferred measure of inflation–the change in the personal consumption expenditures core price index–remains at about 1.2 percent, well below the central bank’s target of 2 percent.

Source: Bloomberg

Chairman Bernanke also highlighted “tightening financial conditions” in this statement–likely a reference to the rise in interest rates since May and the consequent drop-off in rate-sensitive measures such as the Mortgage Bankers Association Purchase Applications Index, which tracks the number of weekly mortgage applications to purchase new homes.

Source: Bloomberg

Mortgage purchase applications tumbled from May through early September, as rising rates curbed consumers’ interest in purchasing new homes. Given the importance of the recovering US housing market to the strengthening economy, expect the Fed to consider housing and credit conditions when it makes the decision to begin phasing out quantitative easing.

Cruising with the Top Down

Our model Portfolios reflect a balanced strategy that combines top-down analysis of macroeconomic trends with bottom-up due diligence on the publicly traded companies that stand to benefit the most. Since we launched Capitalist Times Premium on June 20, 2013, we’ve highlighted a number of buying opportunities that arose from overblown fears surrounding the end of quantitative easing.

Our strategy has worked: The names in our Wealth Builders Portfolio have generated an average return of 8.4 percent, with our picks besting the S&P 500 by an average of 5 percent over the same holding period. In fact, only two of these dozen stocks have lagged the S&P 500.

Source: BloombergCapitalist Times Premium

In the most recent issue of Capitalist Times Premium, we highlight one industry that’s likely to benefit the most from gradually rising interest rates: life insurers.

For a limited time, Capitalist Times Premium is available at a special introductory rate of $69 per year by subscribing online or calling our customer service manager, Sherry, between 9 a.m. and 5 p.m. ET, Monday to Friday, at 1-888-960-2759.

Elliott H. Gue is founder and chief analyst of Capitalist Times Premium and Energy & Income Advisor.

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