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Regular readers or viewers of the financial media are no doubt familiar with the buzzword of the moment: "tapering." That's the notion that the Federal Reserve will begin to reduce its quantitative easing (QE) effort before 2014 by cutting back on its purchases of longer-term Treasury securities and agency mortgage-backed securities. Because such a reduction in bond purchases has always been predicated on sustainable economic growth—particularly a long-lasting improvement in the labor market—market participants should welcome tapering and the stronger economic implications associated with such a move.
Unfortunately, on June 19, an economically optimistic Fed suggested that it will be able to taper, even though most investors seem not to share the Fed's optimistic economic expectations. That disagreement was evident in the ensuing sell-offs in equity and fixed-income markets.
The central bank noted in its June 19th policy communiqué "the downside risks to the outlook for the economy and the labor market as having diminished since the fall."1 The Fed has, historically, erred on the side of economic optimism, and its current forecasts seem to continue in this vein. Its central tendency for economic growth for 2013 is a range of 2.3–2.6%,2 a slight reduction from the previously issued range but still higher than most economists expect.3 Were stronger growth to unfold, the case for tapering would strengthen.
But economic releases over the past few weeks suggest otherwise. In evaluating when to withdraw monetary accommodation, the Fed will have to look carefully at a number of data points. And given the recent rise in interest rates those data points may not indicate enough strength to free the Fed from its $85 billion in monthly securities purchases.
Job growth must be primary among those indicators, given the Fed's self-imposed mandate to reduce unemployment. A sustainable growth level of 200,000 jobs per month has emerged in comments by two Fed district bank presidents, Eric Rosengren of Boston and Charles Evans of Chicago. That threshold has been given further credibility by two former Fed economists who recently suggested that several months of job growth averaging at least 200,000 would be needed for Fed chairman Ben Bernanke and the Fed to justify tapering.4
But the most recent gains in nonfarm payrolls—175,000 in May and 165,000 in April—have fallen short of the criteria the Fed may require.5 The continuing impact of sequestration through the U.S. fiscal third quarter, and the attendant restraint in government expenditures, has created an environment in which an increase to sustainable monthly job growth of 200,000 or more seems difficult and unlikely.
The most recent issue of the Fed's Beige Book on regional economic conditions cites strength in manufacturing, consumption, and job growth.6 If all three were to continue their improvement, the Fed's economic optimism might be justified. Unfortunately, the most recent ISM manufacturing report7 indicated contraction not expansion, the latest Dallas8 and Empire9 manufacturing indexes were disappointing for May, and the May employment report showed a loss in manufacturing jobs for the third consecutive month. Personal spending contracted in the most recent month, and the savings rate at 2.5% offers little reserve to support expanded consumption, especially when year-over-year wages are up only 2%.10
And job growth, while exceeding 200,000 per month from November through February, has fallen short of that mark since then, likely a consequence of sequestration and possible uncertainty about the impact of healthcare legislation.
Economic factors, therefore, may fall short of what the Fed requires to reduce QE. Equally effective is the rise in interest rates since the beginning of May. Anticipation of tapering pushed rates higher throughout May and into June, moving the yield on the 10-year U.S. Treasury note from about 1.62% at the beginning of May to nearly 2.3% in early June, according to Bloomberg data. Mortgage rates also rose, exceeding 4% at the end of May. As a consequence, mortgage applications fell consistently throughout May, a potential concern for economic growth provided by recent strength in the housing sector. Reaction to the Federal Open Market Committee's June 19th policy announcement pushed the yield on the 10-year Treasury note above 2.4%, according to Bloomberg data, paving the way for mortgage rates in excess of 4.25%.
Potentially more important is the impact of reduced mortgage refinancings as a result of higher rates. Recently, around 70% of mortgage applications were for refinancings,11 permitting reduced mortgage payments and in the process freeing monies to support spending, economic growth, and jobs. Higher mortgage rates make refinancing unattractive, reducing the economic support that has been provided in recent months.
The impact of higher rates on the housing sector and the potential adverse economic impact of a halt to refinancings must at some point concern the Fed. Essentially, recent market action that pushed interest rates higher has neutralized the economic benefit of lower rates engineered by QE. Even if job growth improves to 200,000 per month, the Fed might postpone tapering until markets calm.
However, in the current environment, the combination of less than desired job growth, new questions surrounding the U.S. manufacturing renaissance, weaker economic fundamentals to support consumption, and the consequences of the recent rise in interest rates may force the Fed in the opposite direction—that is, increasing the amount of bond purchases. Financial commentators may have to retire the term "tapering" and come up with a new catchphrase to anticipate Fed actions.
A Note about Risk: Investing involves risk, including the possible loss of principal. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Bonds may also be subject to call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Mortgage-backed securities are subject to prepayment risk. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. No investing strategy can overcome all market volatility or guarantee future results.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.