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Fixed-Income Insights

Given the recent spate of weaker economic data, the central bank may need to adjust the degree—and timing—of any change to its bond-purchasing program.

For the bond market, the waiting is the hardest part—at least when it comes to the end of the Federal Reserve's program of quantitative easing (QE). Concern that the Fed will start "tapering" its purchases of Treasury and agency debt has pushed the yield on the 10-year U.S. Treasury note from 1.6% at the beginning of May to more than 2.85% by mid-August, according to Bloomberg data. This 1.25% increase seems rather dramatic and is not likely what the Fed expected as a response to its efforts to more clearly communicate policy moves. What's more, the increase in interest rates resulting from the mere anticipation of a Fed move to withdraw accommodation seems to have produced adverse economic consequences.

What happens when the Fed makes tapering official? Will there be more pain once it actually begins? What impact on the economy and investments might we expect as the Fed finally reduces its purchases of Treasury and agency debt over the next nine months?

Tapering Takes Its Toll
The magnitude of the bond market sell-off since early May suggests a clearer market understanding of the importance of the Fed's purchases and the impact they have had on bond prices. To provide some perspective, investors for some time have expressed concern about the market impact of China reducing its exposure to U.S. Treasuries. With the Fed's portfolio of U.S. Treasury and agency securities ($3.53 trillion) now nearly twice as large as China's holdings of U.S. Treasuries ($1.28 trillion), according to data from the Fed and the Treasury Department, it is not surprising that prices have plummeted on fears of Fed tapering.

Of the $85 billion in monthly buying, the $40 billion targeted toward mortgage-related securities represents 50% of the supply of such debt, according to an official of the Federal Reserve Bank of New York.1 The absence of the Fed will affect price support for this sector. It is not surprising, then, that prices have fallen in anticipation of the Fed's withdrawal.

The potential for a reduction in the Fed's purchases of longer-term U.S. Treasuries is also significant. The monthly auctions of 10-year notes and 30-year bonds together have averaged about $36 billion so far in 2013, according to Bloomberg data. The Fed's monthly purchase of $45 billion of long-term U.S. Treasuries is essentially enough buying power to purchase every 10-year note and 30-year bond in the Treasury auctions conducted this year, with billions to spare. Certainly, the Fed is not limiting itself to 10-year and 30-year maturities, but it has defined its purchases as debt of six years or longer.

Clearly, given the market reaction to tapering, the size of the Fed's bond purchases has supported prices at higher levels than other investors would pay. The rise in yields since the discussion of tapering began may reveal the yield levels needed to attract buyers to replace the Fed. It may be argued that investors have overreacted to the prospect of Fed tapering. However, if over the long term the yield of the 10-year U.S. Treasury approximates real gross domestic product (GDP) plus inflation, a return to that historical relationship suggests that yields may eventually head higher, not lower. (Based on data from the Bureau of Economic Analysis and the Bureau of Labor Statistics, annual GDP growth at 1.7% for the second quarter plus the 12-month Consumer Price Index of 2.0%, as of July, suggests a yield of 3.7%.) Investors must be concerned that prices may continue to fall and, correspondingly, yields rise.

A Hobbled Housing Recovery
Fed board members, and the central bank's chairman, Ben Bernanke, must share those concerns. Echoing the rise in Treasury yields, 30-year mortgage rates, since early May, have risen more than 1%, to 4.7%, as of mid-August, according to data from the Mortgage Bankers Association (MBA).2 While this is still historically low, mortgage applications for purchases have declined by more than 15% from May through early August, according to the MBA. Applications for refinancings have fallen by 55% during the same period.

Any weakness in mortgage lending is a concern, as housing has been a bright spot for economic growth this year. Also, refinancings have supported consumer spending. Both areas had to factor into Fed expectations of improving and self-sustaining growth as we approach 2014. Now some of that economic support is gone.

Similarly, higher rates are blamed for the 2.2% drop in July single-family housing starts and a 1.9% drop in building permits3; a 6% dip in August consumer sentiment4; and a reduction in earnings guidance for retail sales at chains from Nordstrom to Walmart.5

Bernanke's Dilemma
Additional economic releases before the September meeting of the policy-setting Federal Open Market Committee (FOMC) may test the "data-dependent" cornerstone upon which the Fed supposedly will base its tapering decision. Bernanke, however, may be in a bit of a bind here. He has stated that the extent of future Fed bond purchases will depend on the strength or weakness of upcoming economic releases. But Bernanke, no doubt mindful of his legacy, may want to at least start winding down the central bank's historic easing before his term as chairman ends in January 2014. If upcoming data reports continue to indicate slower economic growth, the planned September taper will likely be postponed. A continued rise in Treasury yields could produce a similar delay.

Higher yields, however, may find the level that provides a mechanism for their ultimate stabilization, if not a mild reversal. One encouraging sign in that regard has been the renewed investor interest in 30-year corporate bonds. After a near absence of 30-year corporate debt in July, yields rose to levels high enough to attract meaningful buying interest in the market. During the week of August 12, for example, $4.5 billion of 30-year debt was sold by companies, including Shell International Finance, Viacom and Prudential Financial.6 It will be interesting to see if investors continue to have an appetite for high-quality, longer-term debt at current levels.

It also remains to be seen if Treasury and mortgage-backed security rates are high enough to entice investors to purchase the increased supply of such debt that will be on the market once the Fed winds down its quantitative easing effort. This uncertainty in the wake of an already substantial rise in yields argues for caution at the Fed.

The jump in yields attributable to market fears, combined with recent indications of economic fragility, suggest that a prudent Fed approach may be to taper at a slower pace than is currently feared. That strategy may unfold in an initial tapering of $10 billion, to leave monthly bond purchases at $75 billion, rather than the $20 billion reduction that seems more widely anticipated. Alternatively, the Fed could delay the start of tapering to December 2013 instead of September 2013, thereby calming markets. A slower pace of withdrawal, so that QE ends in September 2014 rather than June 2014, might also be well received.

Regardless of how it is constructed, a more thoughtful and responsive approach to tapering from the Fed would benefit both the economy and the bond market. That would be a final act that might prove satisfying

http://www.lordabbett.com/content/lordabbett/en/perspectives/fixedincomeinsights/the-fed-should-think-twice-about-tapering.html

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