How Fed’s 7% Jobless Avoids Deterring Bondholders Is Mystery
Unemployment will fall to about 7 percent in the fourth quarter, according to economists at five of the world’s largest banks, creating more confusion among investors about the Federal Reserve’s bond-buying plans.
Fed Chairman Ben S. Bernanke said last month that the central bank could stop purchasing assets around the middle of next year when joblessness “would likely be in the vicinity of 7 percent.” Bank of Tokyo-Mitsubishi UFJ, Barclays Plc, Citigroup Inc., Deutsche Bank AG and UBS AG all predict the rate will be either at or just above that level in the fourth quarter, six months sooner than Bernanke projected.
“It will definitely pose more communication problems for the Fed,” said Drew Matus, deputy U.S. chief economist at UBS Securities LLC in Stamford, Connecticut, and a former analyst at the Federal Reserve Bank of New York. “And once again, those problems will be of its own making.”
Bond prices have dropped and market volatility has increased in the last six weeks as investors have struggled to figure out the Fed’s plans for its asset purchases. Prices will fall further during the next 12 months, as a faster-than-forecast decline in unemployment pressures the Fed into ending its program early, said Joseph LaVorgna, Deutsche Bank chief U.S. economist in New York.
One consequence of 7 percent unemployment is that the yield on 10-year Treasury notes will rise to 2.75 percent by year’s end, with a further increase to 3.25 percent by next June, after the Fed winds up purchases by January, LaVorgna said. Treasuries advanced today, with the 10-year yield slipping 2 basis points to 2.46 percent as of 9:11 a.m. London time.
“The yield curve will steepen,” because interest rates on two-year notes will be “anchored” by the Fed’s promise to keep short-term rates near zero for a long time, LaVorgna added. The yield on these securities was 0.35 percent on July 1.
Bond-market volatility probably will increase even more later this year, as the drop in joblessness sows confusion among investors about the Fed’s aims, Matus said. Unlike LaVorgna, he doesn’t see the Fed ending its purchases early and instead says policy makers will point to other indicators -- such as continued low inflation -- to justify extending the program until the middle of 2014.
Volatility in Treasuries fell to 97.13 (MOVE) on June 27 from 103.46 the previous day, the most recent data available, as measured by Bank of America Merrill Lynch’s MOVE index. It climbed to 110.98 on June 24, the highest since November 2011, and has averaged 62.55 this year.
James Paulsen says investors shouldn’t be worried by an end to quantitative easing.
“This should be more of a celebratory milestone than a scary event,” said the Minneapolis-based chief investment strategist at Wells Capital Management, which oversees more than $340 billion. “From an equity investor’s standpoint, the end of Federal Reserve easing is a goal. It is reflecting a stronger economy and a wonderful thing.”
Forecasts for joblessness in the fourth quarter of this year ranged from 6.5 percent to 7.8 percent in a separate Bloomberg survey. The median prediction of the 72 economists polled from June 7 to June 12 was 7.3 percent.
The Fed is purchasing $85 billion of assets each month, comprising $40 billion of mortgage-backed securities and $45 billion of longer-term Treasury debt. It has said it will keep buying assets “until the outlook for the labor market has improved substantially.”
Bernanke said on June 19 that the Fed looks at “many factors” in judging the state of employment, including payroll growth and the number of people in the labor force.
“But the 7 percent unemployment rate is indicative of the kind of progress we’d like to make in order to be able to say that we’ve reached substantial progress,” he added at a press conference following a two-day meeting of the policy-making Federal Open Market Committee.
“If we were to get to that level, in my mind we would have accomplished substantial improvement at a faster pace, and I would be very open to considering then a faster pace of reduction in purchases,” he said.
The Fed has been consistently too optimistic about the strength of the recovery ever since the 18-month recession ended in June 2009 -- a fact that New York Fed President William C. Dudley acknowledged in a May 21 speech.
At the same time, the central bank has been too pessimistic about how quickly unemployment would fall from a high of 10 percent in October 2009. In January 2012, policy makers predicted the rate would average 8.2 percent to 8.5 percent in the fourth quarter of that year, according to their central-tendency estimate, which excludes the three highest and three lowest projections. Instead it averaged 7.8 percent, Labor Department data show.
A decline in workforce participation, partly caused by retiring baby boomers, has helped bring the rate down faster than Fed officials expected for an economy expanding at about 2 percent annually.
The proportion of the population in the labor force, either employed or looking for work, dropped to 63.4 percent in May from 66.2 percent in January 2008. While it rose 0.1 percentage point from April, a further decline is possible, said Gary Burtless, a Brookings Institution senior fellow in Washington.
“The U.S. adult population is getting older,” he said. “This means we should expect that labor-force participation will decline if the job market gets no stronger or no weaker. The number of new 60- to 69-year-olds is climbing fast,” and these adults have lower employment and participation rates than younger Americans, “even in a very healthy job market.”
Structural forces, including the aging population, have caused about half the decline in participation since 2008, said Mary Daly, group vice president and associate director of research at the Federal Reserve Bank of San Francisco. The other half can be chalked up to cyclical influences that should reverse as the job market strengthens, she said, drawing back into the labor force Americans who had stopped looking for work.
The transition probably will happen slowly and occur over “more than a couple of years,” she added.
About 7.2 million Americans described themselves as wanting work in May, even though they had given up actively searching and weren’t counted as part of the labor force. That was up from 6.8 million a year earlier, Labor Department data show.
Karen Strong-Daniely, 48, went to Kennesaw State University in Georgia after losing her job at a mortgage company in 2008 following the housing slump. She earned a bachelor’s degree and is in a master’s degree program in public administration.
She’s taken computer classes and says she’s surrounded by “nontraditional students, older students like myself.” While federal, state and local governments have been cutting jobs, Strong-Daniely is optimistic about her future when she graduates in 2014.
“With my degree, I stand a better chance of landing a position than I did before I went to school,” she said.
The Fed’s focus on a 7 percent unemployment rate has raised questions about how much emphasis it will give other labor-market indicators, such as payroll growth, in deciding when to stop buying assets. What’s particularly unclear is how the central bank will react if the jobless rate falls to its new threshold simply because more Americans leave the labor force.
Investors aren’t sure how the end of quantitative easing will play out, said Nathan Sheets, former global head of the Fed’s international-finance division and now global head of international economics at Citigroup in New York. The central bank should explain in greater detail how it expects the participation rate to evolve and how policy will be influenced if it fails to pick up, Sheets said.
“This is creating confusion for the markets about how to interpret the announced guideposts for the unemployment rate,” he said.
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