Fed Notes – March 19, 2014


Written by: Jon McGraw

The FOMC meeting that finished up today didn’t offer any radical changes from previous policy—this being the first with Janet Yellen as chair. Tapering of bond purchases is slated to continue, with another reduction of $10 billion per month, which takes us to a Fed purchase pace of $55 bil./month of Treasury and MBS (at that rate, the wind-down will wrap up later this year).

Comments about the economic environment were focused on the impacts from winter weather, which added a bit of a ‘pothole’ into the recovery from a data standpoint. Based on rough estimates from outside/non-Fed economists, about half of the assumed 1% decline in GDP growth can be blamed on winter weather, although, due to so many crosscurrents, this is difficult to measure precisely. Otherwise, the statement was along the same lines as those of previous meetings, noting general continued improvement.

Another issue of interest was how the committee would approach nearing the 6.5% unemployment threshold (the answer: they removed the reference completely, using ‘maximum employment’ as an objective instead). One out they have is that inflation is not quite up to their target, so the FOMC can continue their accommodation on that basis, but it’s also been speculated (and confirmed today) that qualitative ‘forward guidance’ language might be increasingly used to allow for a longer period of easing and lessened reliance on numerical targets. As it stands, current market estimates are calling for no action on rates until late 2015.

One might wonder why rates need to remain so low, especially considering that this policy was put in place during the ‘emergency conditions’ of 2008 and the need for extraordinary liquidity and accommodative measures at that time. We’re no longer in a situation so dire; in fact, despite growth and employment not being where the Fed would like it to be, both measures have significantly improved over the past 5+ years. From their various comments and writings, the FOMC is most concerned with the upward progress slipping, and that appears to be the rationale for the continued policy. ‘Taper,’ which might appear overly gradual, seems to be the Fed’s most graceful exit from that regime.

What does this mean for asset allocation portfolios?

Likely, more of the same (it’s the surprises that rattle markets). A continued accommodative low-rate environment is a positive for risk assets, which for the most part, means equities. As U.S. large-cap stocks are still trading at close or a just bit above fair value, which leaves room for continued expansion—in fact, ‘fair value’ implies that a ‘normal’ long-term return should be expected. Stock assets may be the likely beneficiaries of continued accommodation, but investors will also be watching revenue and profit growth to see if the cycle started with last year’s price multiple expansion is supported by fundamentals. Smaller-caps may also benefit, but valuations there have been more expensive for some time, which naturally limits our enthusiasm. Also, attractive relative valuations, accommodative Fed policy and an improving economy (coupled with a lack of supply overhang) could benefit REITs, despite normal month-to-month interest rate-oriented volatility. As we have discussed previously, foreign stocks may provide additional long-term recovery opportunity, particularly in the most price-depressed segments such as emerging markets.

Opinions on bonds remain bifurcated, but few (other than the handful of deflation- and catastrophe-oriented market writers) dispute the mathematics of the falling rate cycle that begin in the early 1980’s now coming to an end. Sure, a geopolitical scare or other ‘risk-off’ shock of some sort could push 10-year rates down from 2.7% to, say, 2.5% or lower, but there appears to be a natural bound of ‘real’ interest rate that investors are willing to accept—and we are around the historical lower end of it now. However, the timing of when rates begin to rise will be dependent on the pace of economic growth, Fed policy and inflation—all of which are to be determined. Playing defense in fixed income doesn’t leave one a lot worse off from a return/yield standpoint, but does reduce interest rate risk significantly. A focus on credit instead of duration may continue to work for a bit longer yet.