To Taper or Not to Taper…That is the Question

In a widely watched decision, the Federal Reserve (Fed) surprised markets by not backing off its asset-purchase program.  Most observers were expecting the central bank to begin a modest pullback ($5-10B) in the pace of their continued $85B monthly purchases, so the Fed’s decision to stand pat took many by surprise.

By failing to taper, the Fed signaled it believes there are still lingering questions regarding the strength of the US recovery. The central bank remains focused on the fact that while the labor market is improving, it is doing so at an uneven pace.  The Fed also pointed to the fact that more and more Americans have been dropping out of the labor force.   Most importantly, we believe, the Fed is particularly concerned about the resilience of the housing recovery in the face of rising interest rates. The current pledge is not to raise rates until unemployment falls below 6.5% or inflation rises above 2.5%

Stocks should do well in this environment. Monetary accommodation and strong profits suggest the potential for more growth ahead. For bonds, it’s more of a mixed bag than meets the eye. Yes, short-term rates should stay low helping anchor long-term rates, but looser monetary policy also means more inflation over time, which will eventually lead to a steeper yield curve. Traditionally, the spread between the 10-year Treasury and the federal funds rate reaches a peak of roughly 3.75% when the Fed is at its most accommodative stance.  The Federal funds rate is currently 0.25% which would put the 10-year Treasury closer to 4.00% vs. its current 2.80%.

Larry Summers took his name out of the hat and won’t be considered for the top spot at the Federal Reserve. And while nothing is a slam dunk, it looks very much like current Vice Chair Janet Yellen is going to get the call from President Obama to step up and replace Bernanke.  The political nature of this entire process is very disappointing.  Monetary policy should be independent of politics, but when the Fed becomes a key part of the regulatory process, its independence is more easily compromised.

“We have yet to see any meaningful pickup in the economy’s forward momentum,” says FRBNY chief Bill Dudley, explaining the decision not to go forward with the taper. His comments suggest his current thinking has the taper on hold until 2014.  “As we move into 2014, the fiscal headwinds should abate somewhat.  As that occurs, the improving underlying fundamentals of the economy should begin to dominate, pushing up the overall growth rate.” William C. Dudley, President and Chief Executive Officer Remarks at Fordham Wall Street Council, Fordham University Graduate School of Business, New York City 

As a result of the Fed decision, rates have dropped which has led to positive returns in most fixed income categories for the 3rd quarter 2013.  Looking ahead to the 4th quarter 2013 and 2014 we believe upward pressure on rates will build as the year moves forward.  We have a unique “window of opportunity” over the next few months to continue to prepare fixed income portions of our portfolios for the inevitable rate increases once Fed tapering is removed completely (late 2014).