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Fixed-Income Insights

Here’s a look at how developments in Congress—and at the Federal Reserve—could influence the fixed-income market in the months to come.

The dust has settled—at least for now—from October's debt ceiling/government shutdown drama in Washington. It's time to look at some of the developments in politics and Federal Reserve policy that will affect the fortunes of fixed-income markets in the months ahead.

It's clear that the latest episode of governmentus interruptus weighed on the U.S. economy. Estimates on how much the shutdown subtracted from fourth-quarter U.S. gross domestic product (GDP) vary from as low as 0.1% from at least one Wall Street economist1 to 0.6% from Standard & Poor's.2

More important will be the longer-term impact of yet another round of congressional budget negotiations scheduled to take place in December and January, the outcome of which almost certainly will greatly influence growth. Surrounding those negotiations will once again be the uncertainty that revealed itself in key measures of "animal spirits" in the U.S. economy, including declines in optimism among business executives, consumers, and home builders.3

Watching Washington
Investors certainly will wish that the scheduled congressional budget negotiations in December and January will be less antagonistic, shorter in length, and more fruitful than the drama in October. Indeed, the political calculus may be different in the next round of fiscal discussions. An October 16th poll from public opinion information provider Rasmussen Reports indicates that 78% of voters surveyed would vote to get rid of the entire Congress and start over.4 The political discontent evident in the poll speaks to all members of Congress, and may prompt a greater degree of cooperation in achieving a productive budget compromise.

A pro-growth solution of tax reform and responsible long-term reduction of entitlement spending seems improbable. Even if the Tea Party priority of unwinding the Affordable Care Act is sidelined, the Republicans' hope for lower taxes and less government remains juxtaposed with the Democrats' vision of preserved, if not expanded entitlements—supported by higher taxes, if necessary.

Perhaps it is not beyond belief that some progress on entitlements such as means testing for Medicare, or reducing the Social Security inflation adjustment, is possible in exchange for adjusting caps on discretionary spending. A more popular and cynical view is that some form of additional sequester—i.e., automatic spending cuts—is the path of least resistance when the next budget deadline approaches.

With Republicans focused on reduced spending and Democrats still interested in raising taxes as part of a solution, it is difficult to imagine a budget agreement that will not dampen economic growth to some extent. Accordingly, earlier expectations of GDP growth of 3% or more in 2014 have been modified by the International Monetary Fund5 and at least one money center bank6 to reflect a budget solution that is not pro-growth, a labor market that is unable to achieve monthly job growth of 200,000, and a housing and mortgage refinancing market that is reacting adversely to the increase in interest rates since May 2013. (Indeed, the belated release of the September employment report, with headline nonfarm payrolls growth of 148,000, reinforces the perception of an economy struggling to achieve stronger self-sustaining growth.) GDP growth expectations for 2014 now more frequently approach 2.5%.

Figuring the Fed
As financial markets have aptly demonstrated, such slow growth does not have to result in weak equity and credit prices. Slow growth increases the likelihood of continued accommodative monetary policy by the Fed and a delay of a reduction in the central bank’s $85 billion in monthly bond purchases until evidence builds that better job growth can be self-sustaining, and that interest-rate sensitive sectors of the economy, such as real estate, are at least stable, if not improving.

Expectations of delayed tapering were reinforced by Janet Yellen's nomination to succeed Ben Bernanke as Fed chair and by Congress's "kick the can" approach to the budget and the debt ceiling. Yellen's long-standing reputation as a monetary policy dove, despite one decidedly hawkish stance in 2006, has buttressed investors' interest in riskier assets.

The fact that economic uncertainty surrounding budget and debt ceiling issues was part of the Fed's September 18 "no taper" decision suggests that a repeat of that uncertainty in December and January could postpone an initial tapering decision until March. The resulting prospect of prolonged accommodation has emboldened investors to elevate equity prices and narrow credit spreads.

Investment Implications
The prospect of monetary policy stability through the end of the year and possibly through the end of the first quarter of 2014 suggests stability for U.S. Treasuries and other high-quality fixed-income categories even as the "risk on" trade supports lower-quality debt to an even greater extent. The appeal of higher income while investors wait for an inevitable return to more normal monetary policy—and higher interest rates—will likely support prices of riskier debt, if not improve them. Yield spreads between high-yield debt and the lower tiers of investment-grade debt have already narrowed during October 2013, according to data from J.P. Morgan.

When tapering does begin, the impact of a sequester-constrained U.S. budget on an economy already straining under the recent rise in interest rates will likely lead to a tapering process that takes longer than the nine-month program initially envisioned by Bernanke in the summer of 2013. The end result, however, is unlikely to change. The Fed's gradual departure from the long-term Treasury market seems likely to result in lower prices, and higher yields.

Unless the probability of recession increases over the next several months, the likely steepening of the Treasury yield curve reinforces a lower-quality, lower-duration investment strategy that should offer higher income today while we await more normal monetary policy to unfold when economic growth permits.


1 Michael Moran, "U.S. Economic Comment," Daiwa Capital Markets America, October 18, 2013.
2 Steven Perlberg, "S&P: The Shutdown Took $24 Billion out of the Economy," Business Insider, October 16, 2013.
3 "Small Businesses Skeptical About Future; Optimism Dips," National Federation of Independent Business, October 8, 2013; Richard Leong, "Washington Drives U.S. Consumer Sentiment to Nine-Month Low," Reuters, October 11, 2013; "Builder Confidence Down in October; NAHB Estimates Sept. Housing Starts will Approach 900,000 Units," National Association of Home Builders, October 16, 2013.
4 "78% Want To Throw Out Entire Congress and Start Over," Rasmussen Reports, October 16, 2013.
5 "World Economic Outlook," International Monetary Fund, October 8, 2013.
6 Matthew Boesler, "BofA Slashes Q1 2014 GDP Growth Forecast after Government Postpones Fiscal Crisis until January," Business Insider, October 18, 2013.

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