Fed Notes: September 17, 2014
The Fed meeting ended with few things changing (updated language reflecting the environment), but more important things (rate policy) not changing. The ‘taper’ continued, at an additional reduction pace of $5 mil. Treasuries and $5 mil. MBS, and QE was slated to end at October’s meeting. Two committee members dissented today, albeit for slightly different reasons—one arguing the pace of improvement warranted for a faster removal of stimulative conditions; the other (as last time) disagreed with the use of certain time-dependent guidance language.
It’s again about the message. Prior to the meeting, there was a great deal of conversation surrounding the potential change in language—in particular, removing the term ‘considerable time,’ describing the length of the period during which rates would be kept at low levels after the taper of the asset purchase program finally ended. There are actual debates going on about this type of thing in economic circles and what small changes in semantics mean, versus alternative words such as ‘some time.’ These nuances are almost indistinguishable at first glance and most investors who don’t follow these things as closely wouldn’t even notice, but a change of any kind from a prior message is seen as significant, and the countdown to what happens next starts from there.
The current ‘dashboard’:
Economic growth: Better, but continues to be slow, at least compared to prior/more normal recoveries. This may lengthen the cycle, however. Strong results from autos and improved capital spending has been tempered by weakness in housing, which has historically been a more buoyant element in recoveries.
Monetary stability/inflation/rates: While lending has improved, credit standards remain tight and cautious, so have not caused a flood of money through the system as first feared. Inflation has remained below the Fed’s target, albeit subject to volatility in energy prices and high food prices. Today’s CPI was below expected.
Employment: Better by headline metrics, and by some secondary metrics as well, but improving at a slower pace than the Fed would prefer. Questions remain about how ‘cyclical’ versus ‘structural’ these employment issues are, which gets to the heart of how solvable they are via Fed policy.
In recent months, speculation about rate moves has waxed and waned based on how the most recent data release happened to look. This month, the poor August payrolls report gave doves some hope for an even longer stretch of extraordinarily low rates; unfortunately for economists hoping for a longer low rate stint (but fortunately for the economy at large), the trend is certainly towards improvement. We don’t know the exact month/meeting when the Fed will change policy, but no doubt waiting for them will be too late—bond markets will react in advance as they are prone to do. If rate increases are slow/gradual, it may not mean catastrophe for bonds, but it may not be a picnic either. A sudden rate hike would be much more damaging, and why we have opted to play a bit more ‘defense’ than ‘offense’ with taking on lessened duration/interest rate risk in fixed income. With the assumption being that the underlying economy is continuing to improve (the impetus for rate hikes), credit risk could theoretically hold up a bit better.
What is the Fed’s ultimate interest rate objective? If there was one longer-term, it’s probably somewhere around 4%. The exactness of this number isn’t as strange as it appears, and is underpinned by several assumptions, including the ‘Taylor Rule,’ developed to figure out what an ideal rate should be for any point in time (and used by the Fed, at least in some derivative form). It basically consists of a 2% inflation goal + a 2% real rate, which is about the long-term average of history. We never seem to get to that perfect place, at least not for very long, but it’s not a crazy framework to start from.
How about equities? We’re not as cheap as we were a few years ago, but that doesn’t necessarily mean a bubble is forming in our midst. Lower rates for a longer period of time act as a positive stimulant, and lowers the risk-free rate inputs into things like dividend discount models—which raises fair values.
In asset allocation portfolios, it’s a relative competition—benchmarks aside, which assets give you the best chance of a better winning percentage while also avoiding losing unnecessarily? By this measure, large-cap U.S. stocks continue to be favored, foreign equities provide opportunity as well, while the highest-quality government bonds offering low rates continue to offer very low real yields as compensation for a significant level of rate/inflation risk. If the wildcard, inflation, perks up to a more significant level at some point, the alternative areas of real estate and commodities may become increasing important again as well.