As a spectator of Alfonso Cuaron’s Gravity, my only thought a few seconds after Sandra Bullock’s character spins wildly into space was “how is all of this going to end?” Would the good looking, level-headed, experienced space-walker played by George Clooney miraculously save the day? Would Houston (mission control) brave a daring, extremely expensive rescue? It was not clear to me how the next ninety minutes would unfold. I was resigned to take a Dramamine, for fear of nauseating motion sickness, and hope for the best. Amen.
A similar reaction as an observer of recent political and market developments (i.e. government shut down, debt ceiling, tapering, and a new Fed Chairman nominee) is understandable, but ill advised. Unlike the casual movie goer, you and your firm have an invested interest in the latest news. Here at Chatham we are view neutral on the path of interest rates. But that does not mean we turn a blind eye to news; we want to think critically on how it will impact capital markets and our clients. Herein, we explore the market uncertainty leading up to the FOMC’s meeting in September combined with Janet Yellen’s nomination as Fed Chairman, and what these together could mean for future Fed policies.
In Mid-July, Chatham held our third semi-annual market update webinar. The focus of the discussion centered on the steepening of the yield curve in the wake of the June 2013 FOMC meeting. Despite softer than desired inflation, continued high unemployment numbers, and an indication in the FOMC’s August press release that economic activity had decelerated somewhat over the first half of this year, the market strongly interpreted the FOMC’s June statement to be a clear indication that tapering (the cessation of the Fed’s $85bn monthly asset purchase program) would begin with the start of the fourth quarter. In the days following the June press release, interest rates continued to rise and remained elevated through August into mid-September. But the markets were wrong: the higher rates in the days and minutes leading up to the Fed’s announcement on September 18th showed evidence that expectations were for a small pace of asset purchased. In the days following, the 10 year US treasury yield slid nearly 30 basis points.
The September FOMC meeting minutes released last week revealed little change from previous periods – overall there is modest growth. The labor markets expanded at a slower pace than during the first half of the year, and inflation through July and August was 1½ percent over the preceding 12-month period. The Committee’s forecast for real GDP over the medium term was revised downward with an expected acceleration in 2014 and 2015 as consumer/business sentiment continued to increase, credit availability improved, and accommodative monetary policy continued. Economic headwinds cited for slowing the pace of recovery remained the household-sector’s deleveraging, tight credit conditions for some households and businesses, and fiscal restraint. Also of notable inclusions were repeated references to the “sizable increases in interest rates since the spring” and a single reference to “the possible fallout from near-term fiscal debates.” See below:
“Participants discussed financial market developments, including their views on the extent to which the rise in longer-term interest rates since May reflected growing confidence about the economic outlook or a perception by financial markets that monetary policy would be less accommodative going forward than had been previously anticipated… While acknowledging that it was too early to assess the effects of such an increase, they expressed concerns that tighter financial conditions might weight on the recovery of the housing sector”*
The information they presented was, for the most part, consistent with macro-economic expectations (if not a little on the side of disappointing). Yet what is interesting is that the Committee’s decision regarding the path of monetary policy was not unanimous. The minutes highlight a considerable degree of debate as to whether or not to decrease the pace of asset purchases. They fall, primarily, into two competing camps.
Keep the status quo: in general this portion of the Committee found the incoming data to be insufficient. The members in this side of the camp were not adequately confident of continued progress, and pointed to near-term risks: the market’s reaction to the Fed tightening monetary policy amidst less than optimal data causing undesired effects in the housing market. Market participants interpret this to mean that the start of tapering could lead to a considerable rise in rates as investors exit US treasuries, especially those with longer duration, which the Fed has specifically been purchasing to keep long term rates low, for other assets.
There were those that spoke in favor of slowing down the pace of securities purchases. They also, perhaps confusingly to the public, pointed to the same set of data but viewed it as consistent with the outlook laid out in the June FOMC meeting when the plan to reduce the level of securities purchases was made public. Concerns with the credibility of forward guidance, and the predictability of monetary policy were the driving arguments. The point was raised that the Committee could make it more difficult to taper in the future, absent stronger economic data, if it did not pare back its purchases under these circumstances. Market participants interpret this argument to be in favor of reducing volatility. In recent history, the Fed has become much more reliant on providing clearer direction through press releases of future policies. Their decision not to follow through with previous communications could be perceived as pessimism.
Their internal debate highlights an important fact that the composition of the FOMC and its leadership really matters. The nomination of Vice Chair of the Board of Governors, Janet Yellen, is an important choice. She was instrumental in helping the FOMC nudge towards its commitment to keep the Fed Funds Target close to zero until the unemployment rate drops to 6.5% and continue quantitative easing until the unemployment rate reaches 7.0%. If her nomination leads to appointment, it will likely signal continuation of dovish policy responses if economic headwinds slow expected growth, and less hesitation to use extraordinary means to fight weak growth in the labor markets.
Thinking back on it, I couldn’t have even begun to guess all of the plot twists, the available resources open to the characters, or the ingenuity of humankind as I watched Gravity unfold. But that didn’t stop me from attempting to solve Miss Bullock’s problems from my comfortable seat. No doubt, the same compulsion takes over when one considers the plot twists and choices involved in monetary policy decisions. But unlike in the movies, each FOMC scene sets the stage for the next decision, and not even the actors themselves can know the outcome, even if they know the path they want to be on
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* Federal Open Market Committee September 2013 Meeting Minutes, Page 5. Released October 9, 2013, Permanent Link: https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20130918.pdf