Less Tapering Becomes Tighter Credit No Matter What Fed Says
Federal Reserve Chairman Ben S. Bernanke sent bond yields a percentage point higher just by talking about adding stimulus at a slower pace. The rout serves as a warning to monetary policy makers that their exit from record accommodation won’t be easy to control.
The jump in yields has pushed up the cost of mortgages for millions of Americans, curbed demand for homes and prompted thousands of job cuts at Bank of America Corp. and Wells Fargo & Co., all at a time when the Fed’s policies are aimed at creating jobs and supporting housing.
Bernanke has stressed that any reduction in the amount of money the central bank pumps into the financial system each month doesn’t mean policy is getting any more restrictive. That message hasn’t been heeded by bond investors, demonstrating how hard it will be for the Fed to control long-term interest rates as it moves toward tightening, according to Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey.
“Getting out of ultra-low interest-rate policy was never going to be easy, and this is a perfect illustration of why,” Crandall said. “It is possible that this will make it even harder because the market will be even more primed to view inflection points as messy and destructive, and therefore a reason to sell early.”
Fed policy makers meeting today and tomorrow will probably lower the monthly pace of bond purchases by $10 billion, to $75 billion, according to the median response of 34 economists in a Bloomberg News survey on Sept. 6. That’s down from expectations of a $20 billion reduction in a July survey.
Higher borrowing costs are the main reason policy makers have “pushed back the tapering schedule” and lowered expectations for the size of the cuts in their bond purchases, Crandall said.
Yields on the benchmark 10-year Treasury note climbed as high as 2.999 percent Sept. 5 from 1.93 percent on May 21, the day before Bernanke said that the central bank could “take a step down in our pace of purchases” in the “next few meetings.” Yields were little changed at 2.86 percent at 11:06 a.m. in New York after dropping two basis points yesterday on former Treasury Secretary Lawrence Summers’s withdrawal as a candidate for Fed chairman, prompting speculation the central bank may be less aggressive in slowing monetary stimulus.
Bernanke has said he expects the Fed to complete its asset-purchase program in the middle of next year when the unemployment rate is around 7 percent, down from August’s 7.3 percent. Bernanke and the Federal Open Market Committee have said they won’t even consider raising the federal funds rate, now near zero, as long as unemployment is 6.5 percent or higher.
Bond traders aren’t convinced by Bernanke’s efforts to divorce tapering from the Fed’s interest-rate outlook. Traders are suffering the worst losses in Treasuries since at least 1978, and they’ve lifted their outlook for short-term rates.
Federal funds futures contracts traded at CME Group Inc. gave a 48.8 percent probability as of 5:40 p.m. yesterday in New York that the Fed will lift the benchmark rate by at least a quarter-percentage point at its December 2014 policy meeting. That’s up from a 42.3 percent probability assigned by the market as of the start of June, and 26.9 percent at the end of the first quarter.
“The irony of the recent move in the bond market is, I think, it lowers the odds of a Fed tapering because it’s not driven by growth and inflation,” said Ethan Harris, co-head of global economics research at Bank of America in New York. “It’s a market that wants to sell off, and we’ve got a loss of confidence from investors who don’t want to be in front of this tank.”
Harris predicts the Fed will wait until December to pare its bond purchases, in part because higher bond yields are making policy makers “a little bit nervous” as the housing market shows signs of “wobbling.”
Purchases of new U.S. homes plunged 13.4 percent in July, the most in more than three years, raising concern higher mortgage rates will slow the real-estate rebound. Mortgage applications have fallen in 15 of the last 18 weeks, reaching the lowest level since October 2008 in the week ended Sept. 6, according to a Mortgage Bankers Association index.
The average rate on a 30-year fixed-rate purchase loan was 4.57 percent in the week ended Sept. 12, close to a two-year high, according to McLean, Virginia-based Freddie Mac.
“The Fed is in a tricky spot, and housing has got to be the driver of consumption in this country.” said Rick Rieder, co-head for the Americas fixed income at BlackRock Inc. in New York, which has $3.86 trillion in assets. “The amount they’re going to taper has to be reduced.”
The minutes from the FOMC’s July 30-31 meeting reveal central bankers’ concern about the market’s reaction to a potential reduction in stimulus. They describe volatile financial markets in response to “policy communications” and economic data.
“Some participants felt that, as a result of recent financial-market developments, overall financial-market conditions had tightened significantly,” according to the minutes, which were released Aug. 21. They “expressed concern that the higher level of longer-term interest rates could be a significant factor holding back spending and economic growth.”
At the same time, “several others” at the July gathering said an easing in bank lending standards would “largely offset” the impact of rising interest rates. “Some participants” also said the move may have “helped put the financial system on a more sustainable footing” by prompting the “unwinding of unsustainable speculative positions.”
The Fed has kept interest rates near zero since December 2008 and undertaken three rounds of bond buying that have swelled its balance sheet to a record of $3.66 trillion. The Fed currently buys $40 billion a month in mortgage debt and $45 billion of Treasuries.
Rieder predicts a $10 billion to $15 billion reduction in the pace of Fed asset buying this week, with most, if not all, of the tapering involving Treasuries. A couple of months ago, he said he had been forecasting a $20 billion cut in purchases, split evenly between Treasuries and home-loan bonds.
Policy makers decided against saying anything about their expectations for a slower pace of asset purchases in their July statement because “doing so might prompt an unwarranted shift in market expectations,” the minutes said.
Global equity markets lost $3 trillion in the five days after Bernanke’s June 19 remarks that he may reduce monthly securities buying this year and halt it by mid-2014.
“Things moved more rapidly than the Fed was anticipating or might have desired,” said Peter Hooper, chief economist at Deutsche Bank Securities Inc. in New York. Policy makers have come to realize that their communications on tapering act “as a signal this whole exit process is getting under way.”
Ending the Fed’s third round of quantitative easing carries greater significance than completion of the previous two because QE3 involves open-ended purchases, both in amount and duration, whereas its predecessors were introduced with defined purchase levels over a fixed period of time. For QE3, the FOMC a year ago said it would purchase $40 billion a month of mortgage securities until the labor market improves “substantially.” In December, the FOMC added $45 billion of monthly Treasury buying.
How the Fed handles expectations for ending its bond buying is important for establishing credibility for the interest-rate increases that will follow, according to Crandall.
Policy makers need to stress that they have an “extraordinarily dovish” viewpoint in order to “lock in low rates as long as they can,” Crandall said.
One way to anchor interest-rate expectations would be to expand on their guidance for short-term borrowing costs. An option policy makers discussed in July would be to lower the employment-rate threshold before any decision on raising the federal funds rate, according to minutes of the meeting.
Another alternative officials discussed would be a signal to hold the benchmark lending rate low so long as inflation is forecast to be below their 2 percent target for some time horizon. Currently, Fed officials say they won’t consider raising the benchmark lending rate as long as their inflation forecast is 2.5 percent or below and unemployment is at 6.5 percent or higher. Having a high and low inflation boundary “might be seen as reinforcing the message that the Committee was willing to defend its longer-term inflation goal from below as well as from above,” the minutes from the July meeting said.
Summers’s withdrawal is a potential complication. It threatens to weaken the Fed’s policy message by leaving the succession unsettled just as the central bank considers scaling back record accommodation.
Central bankers have an opportunity to reinforce their credibility by sticking with the guidance Bernanke gave in June that QE3 won’t end before mid-2014, Crandall said.
“With communications you’re always fighting the next war, and you want to show that your promises in one phase turned out to be reliable,” Crandall said. “They’ve got a very important second phase coming, and tapering decisions will all be made with an eye toward reinforcing the credibility of their interest-rate decisions.”
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