Markets are still reeling from Federal Reserve Chairman Ben Bernanke's press conference June 19, when he indicated that the Fed would likely be winding down its asset purchase programs later this year. (See the Fed's statement here.) Today, we quote from two recent commentaries on Bernanke's latest statements, one from Federated's Debbie Cunningham and one from the New York Fed's William Dudley. Federated Investors' latest "Month in Cash", is entitled, "Second guessing the Fed." It says, "Federal Reserve Chairman Ben Bernanke's delivery of his opening statement as the Federal Open Market Committee (FOMC) wrapped up its two-day meeting on June 19 did not flow as smoothly as his past post-FOMC presentations, giving a sense he might not have been fully on board with the language he was asked to read. The statement was, however, a representation of sentiment across the policy-setting committee. It was also in line with what we've been saying for some time -- while it's not being reflected in inflationary levels, keeping rates this low for so long is dangerous, and in light of the progress we've seen in the economic recovery this year, tapering of quantitative easing measures is likely to start in the second half of 2013. It's important to note, as Bernanke did in his press conference, that tapering of QE does not amount to tightening of monetary policy -- it's just reduced easing. Further, the Fed cutting back on purchases of Treasury bonds and mortgage-backed securities is not slamming on the brakes, it's more like easing off the accelerator. The strategy can be adjusted, or even reversed, if economic data starts turning downward again."
Federated's Cunningham writes, "Despite a steady stream of indications over the past few months that the Fed was heading down this path, many were taken aback by the Fed chairman's openness. Nobody likes surprises, and ripple effects spread quickly across all sectors of the markets. Luckily, the upheaval being seen in the bond markets hasn't played through to the money market yield curve. Rates at the short end have suffered by just a couple basis points, with the London interbank offered rates (Libor) curve steepening out one-three basis points in some places—minor effects compared with what is happening in the ten-year range of the bond market."
The piece continues, "The scramble in the markets to react, and even overreact, to the Fed's moves also presented a buying opportunity. Federal funds futures had for some time been pricing in adjustments to the federal funds rate to take place somewhere around the beginning of 2015, but during the past month, those futures contracts have slid forward, toward an anticipated mid-late 2014 adjustment to rates. The opportunity comes because that move might not be warranted --Bernanke made it clear that QE and the federal funds rate are two different issues, and a change to the actual target rate was still "far in the future." In the period since the FOMC statement and Bernanke's press conference, two separate Fed officials have stepped forward to warn that these moves were out of line with the Fed's thinking."
Finally, Cunningham adds, "Repo rates remained very, very low throughout June, ending the month in the one-three basis point range. A number of factors are coming together, however, as we head into July, to provide some expected relief. With the end of second quarter 2013, and some supply coming into the marketplace, we should see repos trading in the high single digits soon. Repos should also get some help, surprisingly, from the $59.4 billion dividend payment from Fannie Mae to the U.S. Treasury. The Fannie Mae payment had initially been seen as a negative for repo rates, as it could reduce the Treasury's need for short-term financing, but the Treasury has since provided guidance that even with the influx of Fannie Mae money, it would still need to go to the markets for short-term cash. With that assurance, the net effect then is that Fannie Mae will be moving out of the cash market and the repo space, allowing some breathing room for others."
Last week, the Federal Reserve Bank of New York's William Dudley also discussed the recent Fed statements. Dudley's remarks say, "At its meeting last week, the FOMC decided to continue its accommodative policy stance. It reaffirmed its expectation that the current low range for the federal funds rate target will be appropriate at least as long as the unemployment rate remains above 6.5 percent, so long as inflation and inflation expectations remain well-behaved. It is important to remember that these conditions are thresholds, not triggers. The FOMC also maintained its purchases of $40 billion per month in agency MBS and $45 billion per month in Treasury securities, with a stated goal of promoting a substantial improvement in the labor market outlook in a context of price stability."
He explains, "In its statement, the FOMC said that it may vary the pace of purchases as economic conditions evolve. As Chairman Bernanke stated in his press conference following the FOMC meeting, if the economic data over the next year turn out to be broadly consistent with the outlooks that the FOMC sees as most likely, which are roughly similar to the outlook I have already laid out, the FOMC anticipates that it would be appropriate to begin to moderate the pace of purchases later this year. Under such a scenario, subsequent reductions might occur in measured steps through the first half of next year, and an end to purchases around mid-2014. Under this scenario, at the time that asset purchases came to an end, the unemployment rate likely would be near 7 percent and the economy's momentum strengthening, supporting further robust job gains in the future."
Dudley tells us, "Here, a few points deserve emphasis. First, the FOMC's policy depends on the progress we make towards our objectives. This means that the policy -- including the pace of asset purchases -- depends on the outlook rather than the calendar. The scenario I outlined above is only that -- one possible outcome. Economic circumstances could diverge significantly from the FOMC's expectations. If labor market conditions and the economy's growth momentum were to be less favorable than in the FOMC's outlook -- and this is what has happened in recent years -- I would expect that the asset purchases would continue at a higher pace for longer."
He continues, "Second, even if this scenario were to occur and the pace of purchases were reduced, it would still be the case that as long as the FOMC continues its asset purchases it is adding monetary policy accommodation, not tightening monetary policy. As the FOMC adds to its stock of securities, this should continue to put downward pressure on longer-term interest rates, making monetary policy more accommodative. Third, the Federal Reserve is likely to keep most of these assets on its balance sheet for a long time."
Dudley adds, "Fourth, even under this scenario, a rise in short-term rates is very likely to be a long way off. Not only will it likely take considerable time to reach the FOMC's 6.5 percent unemployment rate threshold, but also the FOMC could wait considerably longer before raising short-term rates. The fact that inflation is coming in well below the FOMC's 2 percent objective is relevant here. Most FOMC participants currently do not expect short-term rates to begin to rise until 2015."
Finally, he says, "Some commentators have interpreted the recent shift in the market-implied path of short-term interest rates as indicating that market participants now expect the first increases in the federal funds rate target to come much earlier than previously thought. Setting aside whether this is the correct interpretation of recent price moves, let me emphasize that such an expectation would be quite out of sync with both FOMC statements and the expectations of most FOMC participants."
