PulsePoints Interest Rate Perspective 6/18/13

On May 22 the world of fixed income received a jolt when Ben Bernanke referred to the possibility of “tapering” during congressional testimony.  The latest round of quantitative easing, or “QE,” has included the purchase of $85 billion worth of securities each month, resulting in depressed longer term yields (and higher bond prices).  For most consumers, this has resulted in lower rates on long-term loans (mortgages), whereas fixed income investors have enjoyed seeing the position value of fixed income holdings on their monthly statements continuously rise.  The effects of massive government support on fixed income were clear when the mere thought of tapering dried up bids on Bloomberg terminals around the world.  Immediately, the benchmark 10 year Treasury yield spiked and hit an intra-day high of 2.27% in early June.  Long-term rates also moved at a rapid pace, immediately affecting rates on long term consumer debt.                                                                      *Source: Bloomberg

GCP asserts fears of tapering are overblown and rates will likely fall in the short term, although our long-term strategic outlook calls for increased volatility and higher rates in the intermediate and long term.   This belief is based on Bernanke’s past policy and views, the current state of the economy, and our perception of the Fed’s communication policy.

Bernanke’s strategy to combat the financial crisis and induce growth has focused on unconventional monetary policies (QE) designed to control the “long end of the curve” (long-term interest rates).  Whereas traditional Fed policy focuses on direct control of the fed funds rate, which determines short term borrowing rates, quantitative easing was designed as a mechanism for the Fed to heavily influence long-term rates.   The effect Bernanke has been seeking is an increased velocity of money: the Fed has attempted to expand consumer credit and boost spending (consumer spending is over 2/3 of GDP).  The Fed has successfully assisted economic growth; nevertheless, Bernanke has often indicated the economy is on the right path, but the recovery is not complete.

On May 22, Bernanke said: “A premature tightening of monetary policy could lead interest rates to rise temporarily, but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further.”  Bernanke has expressed concerns regarding economic growth and unemployment.  GCP speculates Bernanke is still very cautions regarding the economic recovery based the on the following recent economic indicators released during the second quarter:

•             April 26: GDP Report.  The first quarter grew 2.5 percent, vs. the consensus analysts forecast calling for a 3.1 percent growth rate. This report was disappointing, especially given the .4% growth rate in Q4 2012.  The report showed federal spending was the component with the biggest decline, while the modest rate of growth was supported significantly by consumer spending.

•             May 16: Consumer Price Index.  The CPI report indicated an annual inflation rate of 1.1% and a significant month-over-month drop of .4%.

•             June 3: PMI.  The Institute for Supply Management's manufacturing sample shocked markets with the lowest level of general activity since June 2009, with the number coming in at 49 (above 50 indicates expansion, below 50 indicates contraction). Furthermore, new orders fell substantially, from 52.3 to 48.8, suggesting future readings may continue to indicate contraction in the manufacturing sector.

•             June 7: Employment Situation.   Payrolls increased 175,000 in May, vs. an estimated 167,000.  Despite beating the consensus number, April payrolls were revised down from 165,000 to 149,000.

Combined, these indicators provide a picture of a weak recovery that is currently more so in danger of deflation than inflation.  With large components of GDP deteriorating and the increased reliance on consumer spending to support GDP growth, GCP believes it is unlikely Bernanke would like to see higher long-term rates in the near future.  Moreover, as a professor who arduously studies the great depression, Bernanke is far more fearful of deflation than inflation and would prefer to reverse the current CPI trend.  Unemployment continues to be a concern.  Bernanke indicated tapering would not take place until he sees a few consecutive months of job growth at a rate of 200,000 per month, whereas recent numbers have been falling short of this number.  GCP further asserts GDP growth of above 3% and inflation closer to 2% would likely be needed to convince Bernanke the recovery can continue with reduced monetary support from the Fed.

GCP has been especially interested in the Fed’s communication policy, characterized by efforts to increase transparency.  The Fed has emphatically suggested the fed funds rate (short-term rates) will stay low for an extended period of time.  Bernanke, however, is still attempting to determine how the markets will eventually react to a “normalizing” of Fed policy.   There is little precedent for the current Fed policy, and many policy makers are unsure of how to “unwind” the massive QE programs that have been supporting much of the economy since the financial crisis.  GCP believes Bernanke likely wanted to get a reaction out of the markets by suggesting tapering is an option to better determine what the market reaction will be when the Fed starts to truly “normalize” their monetary policy.  While GCP anticipates a “normalization” of policies and rates in the future, we believe Bernanke will emphasize the current bond-buying program is dynamic and may adjust continuously to economic trends, but we do not believe there will be a reduction in easing over the next few months.