This content was first published on Morningstar.com. All mentions of Treasury bonds refer to US T-bonds, although the sentiment regarding QE tapering affects global bond markets.
With the Federal Reserve refusing to dial down its highly accommodative easy money policy, corporate bond investors recaptured some of the losses they suffered earlier this year. As Treasury bonds rose last week, the Morningstar Corporate Bond Index rose 1.14%, though year to date, the index still registers a 2.99% loss. Most of the losses this year have been incurred from rising interest rates.
In May, when the 10-year Treasury was well below 2%, we opined that as soon the Fed intimated that it would begin tapering its asset-purchase program, interest rates would quickly rise by 100-150 basis points. Since May, rates steadily moved higher, having risen about 125 basis points, and at their peak earlier this month reached almost 3%. The rising-interest-rate trend reversed course last week after the Federal Open Market Committee released its statement, which sent 10-year Treasury bond prices screaming higher, pushing their yield down 14 basis points to 2.73%.
We continue to think long-term interest rates will rise further toward historical norms once the Fed begins to reduce its asset-purchase program, but over the short term, interest rates may decline further. The intent of the Fed's bond-purchase program is to push rates lower than they would otherwise clear the market. Considering that the Fed is the largest buyer of bonds with infinitely deep pockets, we would not try to fight it. Corporate bonds will also benefit from tightening credit spreads. On a fundamental basis, we continue to view corporate credit spreads as fairly valued within the current trading range. The average spread of the Morningstar Corporate Bond Index closed at +144 last Friday; however, with the continuation of easy money policies, we suspect the market will push credit spreads back toward the bottom of the +130-167 range where they have traded over the past year.
If Not Now, When?
The Federal Reserve shocked everybody (including me) by leaving its asset-purchase program unchanged. The Fed acknowledged that economic activity and labor market conditions have improved since it began the asset-purchase program a year ago. In fact, real GDP has grown successively in each of the past three quarters (reaching 2.5% last quarter), and unemployment has steadily dropped. Since the Fed announced the asset-purchase program, unemployment has fallen from 8.1% to 7.3% and about 2.3 million private-sector jobs have been created. The Fed also cited that aggregate hours worked have increased 2.4%, weekly unemployment claims have fallen by about 50,000, and household surveys indicate jobs are more readily available.
Nevertheless, the FOMC cited that tightening financial conditions could slow the pace of improvement; thus, it decided to await more evidence that progress will be sustained before reducing its purchase program. Among the tightening headwinds, we suspect the Fed is focused on the rise in interest rates this summer. Since May, the 10-year Treasury rate had risen to almost 3%, before recently backing off to 2.73%. Over the course of the past year, the 10-year Treasury has averaged 2.06%, ranging between 1.58% and 2.98%. While the recent rise has been painful to long-duration fixed-income investors, over a long-term historical view, the increase in interest rates is relatively modest.
The Fed has expressly stated that the intent of its asset-purchase program was to push down long-term interest rates. As such, the Fed knows that interest rates will increase as it reduces its purchases. Did the Fed believe that interest rates were only going to rise 25-50 basis points and then even out? Back in May, it seemed clear to us that every bond trader and fixed-income portfolio manager in the world would look to reduce duration to avoid losses in a rising-rate environment. At that time, we had estimated that rates would increase 100-150 basis points once the market began to price in an increasingly higher probability that tapering was coming in the near term. It seems disingenuous for the Fed to attribute its hesitancy to reduce what was supposed to be a temporary program to tightening financial conditions based on rising interest rates. Every time the market begins to price in tapering, interest rates will rise toward levels consistent with normalized historical ranges. How will the Fed extricate itself from the asset-purchase program if the labor market is so weak that it cannot survive a modest increase in interest rates from 2% to 3%?
The Fed has been purposely vague about its criteria to wind down this program, only citing that it would need to see "substantial improvement in the outlook for the labor market." Since the Fed hasn't yet reduced the program, we can only infer that it doesn't think that the current improvement is substantial yet. Without any specific metrics, we are left to guess as to what substantial means to the Fed. This evaluation becomes even more difficult as Chairman Ben Bernanke said unemployment has fallen even faster than the Fed had projected. If job growth has been better than anticipated, it would seem to support the case to begin reducing the asset-purchase program sooner rather than later.
The asset-purchase program was intended to be a temporary program to help improve labor market conditions in the near term, yet 12 months later, the markets are still guessing as to how long the monetization will continue. At the beginning of September, we warned that we thought the Fed risked losing some credibility if it did not start tapering. The Fed will need to do some serious damage control over the next few weeks in order to repair its image.
Bernanke said it's still possible that the FOMC may begin to taper later this year. Unless there is a very significant pickup in employment in the next month or two, it's hard to foresee the FOMC beginning to taper before the end of the year. The FOMC has only two more meetings this year. The October meeting does not have a press conference scheduled. It's unlikely the committee would make such a major policy change with only the brief FOMC statement to explain its actions. Bernanke mentioned that the FOMC could schedule a press conference anytime the committee thought it needed to provide additional explanation. However, if the Fed schedules a press conference before the October FOMC meeting, this would paint it into a corner, as it would signal to the markets that the Fed expects the FOMC will be making a change in its monetary policy. Yet, if the FOMC does not make a change in policy at that meeting, then it will further erode the FOMC's credibility, which has already taken a hit.
There is a press conference and economic projections release scheduled after the December meeting, but that is probably too close to when a new chairperson takes over in January 2014. The FOMC would be hesitant to make such a major change in policy before a new chair has the chance to analyze and influence policy. As such, it's possible the FOMC may not begin to taper asset purchases until the March 2014 meeting. If so, and assuming a $15 billion per month tapering schedule thereafter, the Fed may monetize another $710 billion, with the program lasting until next August.
By keeping this extremely aggressive monetary policy in effect for so long, one of the most concerning aspects is whether the economy and asset markets have become so addicted that this liquidity can't be removed without severe withdrawal symptoms. In addition, considering that the Fed is continuing to keep its highly accommodative policy dialed up to 11 (Spinal Tap reference), it doesn't have any have anywhere left to go if some other crisis were to emerge. For example, if U.S. economy entered a recession, if there was contagion from a resurgence of the European sovereign debt/banking crisis, or if a hard landing in China occurred, what would or could the Fed do?
