Quick Market Update
The Yellen Era Begins
JANUARY 31, 2014
Craig Weisenberger, CFA®
Director of Short Term Asset Management
Tracie McMillion, CFA®
Asset Allocation Strategist
In this Quick Market Update:
Yellen faces the challenge of normalizing interest rates
Following an unprecedented term of creative policy action, Ben Bernanke’s final meeting as Chair of the Federal Reserve was uneventful.
Dr. Janet Yellen takes over as the new Chairperson of the Federal Reserve on Saturday, February 1.
The transition from Ben Bernanke to Janet Yellen so far has been a smooth one.
Going forward, Yellen’s Fed will be challenged to effectively manage the normalization of U.S. interest rates amid changes in the global economy.
U.S. Federal Reserve (Fed) Chair Ben Bernanke oversaw his final Federal Open Market Committee (FOMC) meeting this week. In doing so, he closed the door on the era of the largest and most aggressive efforts of the central bank’s 100-year history—the likes of which we may never see again. In the immediate aftermath of the world’s credit crisis, under Bernanke’s watch, the market was flooded with enough liquidity to anchor short-term interest rates near zero. When it was determined that additional stimulus was needed, he devised a plan to lower long-term interest rates by implementing a program to purchase agency mortgage-backed securities and longer-dated U.S. Treasuries (quantitative easing). Against an anemic backdrop of market fundamentals, Bernanke’s plan sought to lower credit costs for businesses and individuals to spur economic growth.
As he leaves his post this week, the U.S. economy appears to be on solid footing, growing at an annualized rate of 3.2 percent during the fourth quarter of 2013. But the Fed’s balance sheet has ballooned to over $4 trillion dollars during his term in office. Dr. Janet Yellen, Vice Chairperson of the Fed, about to assume the Chairperson seat, certainly will have her hands full and will be adequately challenged in the months to come.
Wednesday’s FOMC rate announcement was rather uneventful. The committee voted unanimously (10-0) to maintain the federal funds rate at the 0 to 0.25 percent range “at least as long as the unemployment rate remains above 6.5 percent.” However, with the inflation rate below the committee’s long-range goal of two percent, it stated that “it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6.5 percent.” We believe this is an acknowledgement that with the labor force participation rate falling quite quickly due to the volume of long-term unemployment benefits expiring and number of baby-boomers retiring, the 6.5 percent target has become less meaningful as a gauge of labor market health.
The Fed’s latest statement was relatively unchanged from its December 18 meeting statement. As was widely expected, the Fed announced the monthly pace of bond purchases will be cut by another $10 billion starting in February. This will leave the monthly Treasury purchases at $35 billion per month and Agency Mortgage Backed Securities (MBS) at $30 billion per month. Indeed, despite a weak December payroll number and increasing market volatility, it seems clear that the Fed remains committed to ending the Large Scale Asset Purchase (LSAP) program in 2014.
Source: Wells Fargo Wealth Management, January 31, 2014
Yellen faces challenges ahead
With Bernanke leaving office and his legacy still unclear, Dr. Janet Yellen faces several significant challenges as she takes the helm at the Fed. To many market observers, the Fed’s LSAP program was an effort to elevate asset prices. As the Fed purchased quantities of Treasuries and Agency MBS in excess of net supply, investors were enticed to purchase assets that were more risky. For example, Agency MBS investors may have been enticed to purchase investment-grade (IG) corporate bonds; IG corporate investors may have been enticed to purchase high-yield corporate bonds; high-yield bond investors may have been enticed to purchase emerging-market bonds and so forth. Rising asset prices hypothetically would lead to a wealth effect and stimulate economic growth as a result. Market observers may point to the higher economic growth rates seen in the U.S. during the second half of 2013 and the generally higher global asset prices over the past few years, as an indication that Bernanke’s strategy has been successful on that accord.
Regardless of the original intent of the LSAP program, Janet Yellen is now faced with challenges that no other Fed Chairperson has ever faced. She must effectively unwind $1.5 trillion in MBS on the Fed’s balance sheet and retract $2.4 trillion in excess reserves without initiating significant market disruptions. Another challenge Yellen faces is low inflation. The Fed has a dual mandate to manage inflation and employment. While inflation expectations have begun to rise, the actual inflation rate has been reported well below the Fed’s two percent target. Should the fear of deflation intensify, investors may seek “safe-haven” assets.
While these are legitimate challenges for Yellen, the most immediate fallout from the Fed’s dedication to ending its LSAP is already at her doorstep. Emerging markets seem to be in turmoil due to a number of factors, but as suggested earlier, the Fed’s aggressive bond-buying program may have had a crowding out effect, pushing prices of risky assets higher, including prices of emerging-market assets. As the Fed begins its directional reversal of the program, emerging markets could feel the impact. Even so, it seems apparent the Fed is concerned about market stability, particularly as that stability impacts the U.S. economic recovery. For now it seems content that the disruption in emerging economies will not deter the current U.S. economic momentum.
As the Fed purchased a large percentage of low risk assets including Treasuries and MBS securities through its quantitative easing (QE) program, yields on those assets decreased. Lower yields encouraged investors to seek higher returns from other asset classes, helping to support the global market recovery. Now that the Fed is starting to decrease the amount of low risk assets that it is purchasing, yields on those assets have risen, making them more attractive to investors. The current disruption in the emerging markets is, in part, a re-pricing of risk. We believe the normalization of interest rates in the U.S. will be a long and deliberate process. Nevertheless, we expect episodes of volatility as the Fed’s monetary policy diverges from policies elsewhere in the developed and developing worlds.
We believe maintaining a well-diversified, four-asset group portfolio is the most appropriate strategy for investors to ride through the market uncertainty, thus avoiding concentration risk to any one asset class or any one region of the global economy. We also believe that, like her predecessor, Dr. Yellen, will be thoughtful and if necessary, creative, in how she navigates the challenges that lie ahead for the global economy.
All data for this Quick Market Update was sourced from Bloomberg Finance, LLP, unless otherwise noted.
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