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Note: This is an updated version of an article originally published on December 18, 2013.
Ben Bernanke saved one of his most significant policy moves for last. At the final policy meeting for the outgoing Federal Reserve chairman, whose term is slated to end in January, the central bank decided on December 18 to begin tapering its quantitative easing (QE) program. Modest improvement in job creation over the past several months, increased certainty about the federal budget, and an expected reduction in fiscal drag as a result of avoiding further sequestration allowed the Fed to reduce its monthly bond purchases by a total of $10 billion. The Fed's move surprised many investors who had expected the decision to be delayed until at least January, and more likely March.
In the wake of the Fed's announcement at 2:00 p.m. ET, on December 18, the decision was largely discounted in the Treasury market. According to Bloomberg, the yield on the 10-year Treasury note ended the session at 2.87%—the same level it was at on September 17, when the tapering announcement was first expected. Stocks welcomed the news, with the S&P 500® Index rallying to a record close on the day.
In a statement, the policy-setting Federal Open Market Committee (FOMC) said that in light of better labor market conditions, it would "modestly" reduce the pace of its bond purchases under the QE program.1 Beginning in January, the Fed will scale back its monthly purchases of agency mortgage-backed securities from $40 billion to $35 billion, and of longer-term Treasury securities from $45 billion to $40 billion. The Fed said that its "sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative."
The Fed left itself some room to maneuver, saying that decisions on any future changes to QE "will remain contingent on the Committee's outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases."
The central bank also maintained its ultra-low target range for the fed funds rate of 0 to 0.25%, which "will be appropriate" as long as the unemployment rate remains above 6.5% and longer-term inflation projections are no more than a half percentage point above the Fed's longer-run goal of 2%.
Note that the Fed's tapering test-run will not start until January, and then with reductions of only $5 billion in purchases of mortgage-related securities and $5 billion in Treasury and agency securities. Because the Fed will not yet see the results of its latest policy change by the time of its next meeting in January 2014, it seems likely that the size of tapering will not increase before the FOMC meeting in March. Such a slow and deliberate tapering process should calm investors who are fearful that replacement buyers may not emerge quickly after the Fed begins to scale back its current $85 billion in monthly bond purchases.
What does that mean for interest rates? Over the next nine to 12 months, we expect an eventual slow rise in interest rates, rather than a spike, as the Fed reduces its bond purchases. Eventually, longer-term Treasury yields will creep higher as tapering continues in "measured" steps, but a big jump over the next couple of months seems unwarranted. The central bank's emphasis on maintaining its zero-interest rate policy regarding the benchmark fed funds rate should provide some protection to shorter debt maturities. Bonds of lower credit quality should also fare better in an environment of continued, albeit slow, economic growth.
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. 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.
Yield is the annual interest received from a bond and is typically expressed as a percentage of the bond's market price.
The S&P 500® Index is a market capitalization-weighted index of common stocks.
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.