Finally, the FOMC did it!

The decision of the FOMC has been long telegraphed and was finally made seven months after outgoing Fed chairman Bernanke made his famous statement during a testimony at Congress. One might assume that the recent US labor market report, which was surprisingly strong, tipped the balance within the FOMC. However, in the first two sentences of the statement, the FOMC writes “Information received since the Federal Open Market Committee met in October indicates that economic activity is expanding at a moderate pace. Labor market conditions have shown further improvement; the unemployment rate has declined but remains elevated.”

This could be interpreted like the committee could have waited also one or two more meetings for making the decision to reduce the volume of monthly bond purchases by $10bn to $75bn. Thus, other considerations might also have played a role. One possible reason might be the looming end of Mr. Bernanke’s term as Fed chairman on January 31, 2014. He was the architect of quantitative easing by the Fed. Thanks to his policy, the US economy performs better than the Eurozone. But his policy is also strongly criticized by Tea Party politicians, who do not understand how monetary policy works. Thus, it would not be surprising if Mr. Bernanke would also like to be the Fed chairman starting to exit quantitative easing.

The fear of tapering had a negative impact on financial markets. Whenever economic data was stronger than expected, markets feared the exit from QE3 and stock as well as bond prices declined. Taking the decision reduces the uncertainty in financial markets. The yield on the 10yr US T-note edged up only slightly compared to the close of Friday, December 6, when the US labor market data was released. Thus, decision was already priced in by the fixed income markets.

The December FOMC meeting is one of the four quarterly meetings, where the committee presents its projections and the Fed chairman explains the monetary policy at a press conference. While various FOMC members already pointed out that tapering would not imply an end of the zero interest rate policy (ZIRP), it was a good occasion to demonstrate that the Fed Funds rate will remain at the extremely low level for quite some time. The majority still expects that the first rate hike would take place in 2015. Also important is that the majority expects that the Fed Fund rate would be at 1% or less by the end of 2015. Furthermore, the FOMC made clear that a fall of the unemployment rate below the level of 6.5% would not be an automatic trigger for a rate hike. Instead, the Fed Funds rate will remain at the current level for some time after this level will have been reached. This assurance was welcome in the bond market and triggered a rally at the stock market.

For forecasting the direction of the 10yr US Treasury yield, the money market rate implied in the Eurodollar Futures at the CME maturing within the next 12 – 15 months provides a good guideline. Thus, we analyze the implied 3M Libor of the March 2015 Eurodollar Future. Currently, this implied 3M Libor rate is at 0.495% while the current 3M Libor rate is at 0.248%. Given the projections of the FOMC that the first hike of the Fed Funds target rate would take place in 2015, the timing of this move would be critical. As long as the FOMC would not increase the first quarter of 2015, the implied 3M Libor per March 2015 could even edge down further, which would limit the upside potential for the yield on the 10yr US T-notes. Only if the market starts to price in rate hikes in the short-term interest rate futures, the long end of the US Treasury curve has to be expected to come under stronger selling pressure.

The spread between the yield on the 10yr US T-note and the 3M Libor is at 239 basis points. The steepness of the yield curve, combined with the limited risk of higher Treasury yields, makes carry-trades interesting for banks and hedge funds. Therefore, the declining demand from the Fed might be easily compensated by other buyers, like banks and hedge funds.

We pointed out that the macroeconomic fundamentals would argue for investments in the US stock market even in the case of tapering. Nevertheless, given how the stock market reacted before the FOMC decision on stronger economic data, a negative reaction on the decision to reduce the volume of monthly bond purchases could not be ruled out. Especially, as many market pundits claimed that the rise of stock indices were only caused by the extension of the Fed balance sheet. However, the precious metals reacted as expected. Gold reached the lowest weekly close of this year. The correlation between gold and the S&P 500 index turned negative in 2013. Thus, the rally in the stock market following the FOMC announcement caused further funds flowing out of the precious metals and into equities. The holdings of the SPDR Gold Trust ETF dropped to 808.7 tons, which is a fall of 40.1% compared to the same day last year. While the FOMC underlined the outlook for stable interest rates, the US dollar gained against other major currencies as dealers bought the dollar on less liquidity provisions by the Fed. Thus, the increase of the US dollar index was another factor, which weighed on the precious metals. As long as the US stock market remains strong and the US dollar appreciates against the major other currencies, gold might not have reached the bottom. Thus, the low of the downswing starting earlier this year is probably still ahead.   

No reason to fear tapering

The US labor market report was stronger than the consensus of Wall Street economists predicted or whisper numbers among traders indicated. Before the release of the report, markets feared a stronger report would signal the Fed would taper at the next meeting. However, financial and commodity markets only briefly traded lower but after a few minutes reversed direction and traded higher. Thus, many markets traded like it was selling the rumors and buying the facts. Nevertheless, neither the S&P 500 Index nor most precious metals managed to end the week higher than the Friday before.

In a market report published by ThomsonReuters, one trader was quoted that US stock markets trade higher because the market now knows that the economy would be able to absorb the negative impact of tapering by the Fed. This statement just underlines that financial markets are not always information efficient as academic theory postulates. For more than six months now, the Fed emphasized that the decision to reduce the volume of monthly bond purchases would be data dependent. This implies, that the FOMC would only decide to taper if the majority of the voting members were convinced the economy were on a sustainable growth pace, which implies that tapering would not hurt the economy.

Some analysts and asset managers argued that the rally in stock and commodity markets were driven only by the liquidity provided by the Fed. If this argument were correct, then stock markets were in a bubble. Precious and industrial metals as well as the markets for agricultural commodities corrected this year. Thus, the liquidity of the bond purchases did not flow into most commodities any longer. For gold and silver, we pointed out in this blog that the shift in Japan’s economic policy to overcome the deflation was the crucial factor for the correction. For industrial metals it was high stockpiles and fears about Chinese GDP growth, which dominated the market developments. Thus, for the commodity markets, the argument that only the Fed liquidity injection by QE3 drove prices higher was obviously wrong. But is it also wrong for US stock markets?

We developed some macroeconomic indicators for various stock market indices, which are all based on the macroeconomic portfolio theory of Prof. James Tobin, which he created to study the economic impacts of fiscal and monetary policy measures. This indicator does not include any monetary aggregate like money supply or the size of a central bank’s balance sheet. The indicator is based on monthly macroeconomic variables which are highly correlated with GDP growth. Also short- and long-term interest rates are included.

As the chart shows, the macro-indicator only had a brief decline in the second quarter this year. The shaded area indicate when a moving average of the indicator is increasing and thus provides a set-up for a buy signal. It is worth to note, that the macro-indicator rose in the second half despite the yield on 10yr US Treasury notes provided a negative contribution on balance. The major moves higher of the S&P 500 index took place when also the macro-indicator signaled a bullish environment for the stock market. Thus, we have to come to the conclusion, that QE3 was helpful for the stock market rally, but the rise of equity prices was not driven solely by the Fed buying bonds but also by favorable macroeconomic fundamentals.

Furthermore, we have to conclude that the fear in some financial markets about the impact of tapering are overdone. They were only justified, if tapering would lead to a deterioration of economic fundamentals. However, the FOMC also emphasized that the volume of bond purchases could be increased again if the economic development worsens after the committee decided to taper. Therefore, the downside risk for the US economy appears to be rather limited as the FOMC remains ready to act when needed.

After the release of the US labor market report, the question is now, whether this report would now tip the balance among the FOMC voting members already at the December meeting. The decline of the unemployment rate to 7.0%, which was accompanied by people returning back to the workforce is certainly a strong argument. Also the number of job creation is more robust than economists predicted. However, in the Beige Book, which serves as a basis for the FOMC decisions, the regional Reserve Banks preparing the report, paint a picture of modest economic development. Thus, from our point of view, a tapering decision at the next meeting appears still not as the most likely scenario. However, the probability for reducing the volume of monthly bond purchases in Q1 next year has clearly risen. 

Nevertheless, there is no reason to fear tapering. The rise of the US stock market was well supported by economic fundamentals. The Fed will keep the short-term interest rate, the Fed Funds target rate unchanged well into 2015. The yield on 10yr US Treasuries has risen further to 2.88%. Thus, the yield curve is rather steep and attractive for carry trades, which should limit the upside risk in the US Treasury market. But tapering might be positive for the US dollar, which might appreciate against major currencies as the ECB and the Bank of Japan will continue to stick to a very expansionary monetary policy. For the metals markets, the risk of a firmer US dollar is the major risk of tapering by the Fed. But as the FOMC heralded this move for more than six months, it should now be priced in. 

Focus on US Labor Market Report – But no Signal for Tapering at next FOMC Meeting

The fear that the FOMC might start tapering in December is back after the release of the minutes of the October FOMC meeting. Thus, financial and commodity markets will focus on the US labor market data, which is scheduled to be released on December 6. However, we do not expect that this report would already tip the balance. From our point of view, tapering is more likely to take place later in 2014.

The minutes of the recent FOMC did not bring any real surprise. On the one hand, it should not have come as a surprise that reducing the volume of bond purchases was discussed. Also the preparation of markets that this event could take place within the next few months is not really new. Since the testimony in May, when Fed Chairman Bernanke pointed out that the FOMC might take this decision, there were always hints from FOMC members that the committee might make this decision at one of the next few meetings. There was no statement that tapering would be off the agenda. It is only a question of timing.

But on the other hand, the Fed always emphasized also that the decision to taper would be data dependent. During November, Fed Chairman Bernanke and his designated successor Janet Yellen both indicated that the economic situation of the US would not be stable enough despite some improvements. This pointed more towards no tapering in 2013.

Therefore, the crucial question is whether economic data has improved sufficiently to change the mind of the majority within the FOMC. The US labor market report for the month of October was surprisingly strong. The number of new jobs created exceeded the consensus forecast by far and also the numbers for the preceding two months had been revised higher. The government shutdown had not a significant impact on the labor market. For November, the consensus is looking for a smaller number of new jobs created at 184K, which is 20K below the October figure and also below the 12month moving average. It would also be far less than the number of new jobs created in November last year. Thus, the consensus is not looking for a particular strong number, which would probably tip the balance.

But the target of the Fed is not the number of additions to the non-farm payroll. All the statements refer to the unemployment rate, which is calculated from the household survey. In October, the unemployment rate edged up to 7.3%. For November, the consensus predicts that the unemployment rate would edge down again to 7.2%. However, the crucial factor is the labor force participation. A decline of the unemployment rate, which is driven solely by jobless workers leaving the working force could hardly been interpreted as an improvement of labor market conditions. It would be different, if a decline of the unemployment rate were accompanied by workers returning the workforce. Thus, one will have to scrutinize the labor market report carefully. But all in all, we do not expect that the labor market would be strong enough to tip the balance towards tapering at the FOMC meeting on December 18.

In September, the FOMC also argued with the increase of funding costs. After the yield on 10yr US Treasury notes came down from 3.0% to 2.5%, it rose again above 2.75%. This would be another argument against a decision to taper at this month’s FOMC meeting.

It is hard to predict in which direction the labor market report will surprise the consensus among Wall Street economists. Especially, it appears impossible to forecast, whether the focus of the markets will be more on the business or the household survey after the release of the data. But even in the case that the US labor market report were perceived as indication that the FOMC would not decide to reduce the volume of bond purchases this month, it is less likely that bond and precious metal markets would switch to a strong rally mode. Tapering is only a question of timing and thus, the uncertainty about the specific date remains in the markets until the final decision will be made.