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.