September 9th, 2013
Forward Market Report for August 2013
by Jim Welsh, Forward Markets, with David Martin and Jim O'Donnell
In recent years the Federal Reserve (The Fed) has attempted to improve its level of communication so financial market participants could possess a clear understanding of current monetary policy and the future direction of policy. If investors knew what the Federal Reserve was planning, market volatility may be dampened. The post FOMC meeting statement has become more detailed. After every other meeting, Chairman Bernanke conducts a press conference so members of the media can ask more specific questions. Despite the Federal Reserve's best efforts, market volatility has increased in recent months, rather than becalmed.
During Chairman Bernanke's press conference on June 19, the financial markets began a proverbial swan dive. It ended three days later, after the S&P had dropped from 1,651 to 1,560 (-5.5%), and the 10-year Treasury yield had soared from 2.16% to 2.65%.
Members of the Federal Open Market Committee (FOMC) were understandably surprised by the market's reaction to Bernanke's June 19 comments. The Federal Reserve had indicated since May 22 that the tapering of the third round of quantitative easing (QE3) would be data dependent, so nothing had changed in the Fed's message. Market participants had simply not listened that tapering was 'data dependent'. Very similar to a parent who reminds their favorite teenager about the 11pm Saturday night curfew, and is surprised when the teen strolls in at 1130pm. In our June commentary, we thought investors would realize their expectation of a quick end to QE3 was unfounded, which would support another rally that was likely to test the May 22 peak. Investors' understanding was improved after various Fed governors quickly emphasized tapering would not begin immediately and would be, "surprise! surprise!", data dependent. The Fed's message hadn't changed, but market participants had finally listened. In an interesting twist, the majority of market participants blamed the Fed for doing a poor job of communicating. This seemed a bit ironic to us, but not much different than the teenager who blames the parents for not making it clear the curfew was 11pm, and not the 11:30pm they thought they heard.
The data the Fed's tapering decision is dependent on is based on the Federal Reserve's forecast for the remainder of 2013 and 2014. The Fed expects gross domestic product (GDP) growth to accelerate to 3% by the end of 2013, and average 3-3.5% in 2014, the unemployment rate to fall from current levels to 6.5-6.7%, and inflation to rise toward 2%. We suspect many market participants concluded tapering might happen sooner than later, because their forecasts for GDP, the unemployment rate, and inflation closely tracked the Fed's forecast. In May and June, the consensus among economists was for the growth rate of GDP to rise in the second half of 2013 and strengthen further in 2014. With most economists and strategists leaning in the same direction, it is no wonder why most market participants thought Fed tapering was a done deal. Seen from this perspective, the selloff in stocks and bonds during May and June makes sense.
For many months our view has been consistent. Here's what we wrote in June.
"Our expectation is growth is unlikely to accelerate as forecast, muting the expected improvement in the unemployment rate. Weak global aggregate demand and excess capacity will keep inflation from rising as forecast. The sharp increase in mortgage rates only reinforces our view."
In the July commentary we noted,
"GDP growth hovered around 2% in 2011 and 2012, even though housing and vehicle sales improved significantly in both years. Gains in housing and vehicle sales are poised to moderate in the second half of 2013, while job and income growth are not likely to accelerate. When all the pieces are put together, it's hard to see how growth is going to pick up to 3% by year end as forecast by the Federal Reserve and many private economists."
The most recent data points on jobs, income growth, consumer confidence, retail sales, and housing have generally supported our view that a meaningful second half acceleration is likely to remain elusive. This could prove problematic for the Federal Reserve in coming months and create a real communication breakdown. The Federal Reserve has said the timing of tapering QE3 is data dependent. On August 6, Atlanta Federal Reserve President Dennis Lockhart made the following statement in an interview with Market News International.
"My more realistic fear is just a kind of ambiguous picture of mixed data that signal neither accelerating strength nor necessarily deterioration, but that kind of moping along in the middle, then I think it's not a foregone conclusion that the asset purchased program should be removed or removed rapidly."
Dennis Lockhart is not a voting member, but his sentiment is likely shared by other moderate FOMC members and certainly the FOMC doves who have been the most ardent supporters of QE3.
However, the hawks on the FOMC have a different set of concerns that are not related to economic data. For one, they are concerned about the negative unintended consequences from continuing QE3. Earlier this year, a number of FOMC members publically discussed the activity in the leveraged loan market, real estate investment trusts (REITs), the overall reach for yield by investors into more risky investments, and the all-time in margin debt on the New York Stock Exchange (NYSE) in April. We thought this was why Chairman Bernanke discussed in his Congressional testimony on May 22 the conditions under which the Federal Reserve would begin scaling back the amount of its QE3 purchases. In deference to the hawks on the FOMC, it was time for the markets to receive a sobriety checkup that would lower some of the leveraged positions in the markets. Longer term, the hawks on the FOMC are also concerned about the ever growing size of the Fed's balance sheet, which poses at least a couple of hazards. According to Federal Reserve data, since late 2010, the Federal Reserve has expanded its balance sheet from $2.3 trillion to over $3.5 through its purchases of Treasury bonds and Mortgage Backed Securities (MBS). The recent increase in Treasury bond and mortgage back security yields have reduced the value of most of the bonds and MBS the Fed has acquired since 2010. The Federal Reserve is sitting on tens of billions of dollars in paper losses, and it isn't clear how the Fed will account for them.
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