Yesterday’s FOMC meeting was a surprisingly eventful one that injected some volatility into financial markets. As expected, the Fed left its target rate of 0 – ¼ percent unchanged and implemented more quantitative easing (QE). It announced additional monthly purchases of agency mortgage-backed securities of $40 billion per month and stated that “The Committee also will purchase longer-term Treasury securities after its program to extend the average maturity of its holdings of Treasury securities is completed at the end of the year at a pace of $45billion per month.”
Out with Forward Guidance, In with Numerical Thresholds
Most interesting was the Fed’s removal of its forward guidance that rates would remain exceptionally low at least through mid-2015, and the introduction of numerical thresholds for its policy rate guidance. It announced the current federal funds rate will be appropriate at least as long as the unemployment rate remains above 6 ½%, as long as inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. The announcement was not surprising. But the timing was.
Market Reaction Contrary to Conventional Wisdom
Most economists and strategists took the FOMC statement to be more dovish than expected and signaled a green light for risk. However, that view was met with a tepid reaction by asset prices. A U.S. dollar (USD) selloff appeared uninspired. The initial equity market rally retraced to flat- to slightly-negative, and U.S. Treasuries sold off across the curve.
I do not believe the statement was more dovish. At best it was neutral. There is a potential scenario whereby the Fed enters the picture sooner than its old forward guidance of mid-2015.
- Unemployment on track to fall below 6.5% sooner than expected – The Federal Reserve of Atlanta has a jobs calculator that enumerates the net employment change needed to achieve a target unemployment rate after a specified number of months http://www.frbatlanta.org/chcs/calculator/.
In my analysis, I’m targeting an unemployment rate of 6.4% just below the Fed’s unemployment rate threshold, a continuing structural decline in the employment participation rate from 63.6% to 63.3%, making the assumption that we maintain a monthly nonfarm payroll gain of 157k (the average of the last 12 months). Should my scenario materialize, we would fall below 6.5% in 2 years – Q4 2014.
- Potential GDP has taken a hit – The Fed believes potential GDP is around 2½% but during yesterday’s press conference Fed Chairman Bernanke admitted that the global financial crisis may have pulled down potential GDP.
Many Wall Street economists believe the new potential GDP is closer to 2%. This is significant since it explains why the unemployment rate has been improving better than Fed forecasts and could result in consumer price inflation sooner than later.
- Inflation expectations on the rise – The Fed’s measure of inflation expectations are near their highest level since mid-2011 at 2.8%.
Since the inception of the series in 1999, inflation expectations do not stay above 3% for very long. Therefore a sustained move above that level will concern the Fed that inflation expectations are becoming entrenched.
Given the Fed’s accommodative monetary stance and attractive valuations, there is no reason to think equities cannot perform well in this environment.
I have reservations over a sustained period of USD weakness, as the G4 central banks (the European Central Bank (ECB), Federal Reserve (Fed), Bank of Japan (BoJ), and Bank of England (BOE)) have very accommodative monetary policy and among them the Fed action is not unilateral.
Furthermore, I expect additional easing either by the ECB and BoJ in the coming quarter. I believe the risk/reward for U.S. Treasuries continues to favor higher yields, not lower. However, in the long run, markets should not lose sight of yesterday’s FOMC statement that may have laid the foundation for a removal of excessive monetary easing. In this environment, I believe U.S. Treasuries remain highly vulnerable and would be the catalyst for a major USD bull rally.