The adage, “don’t fight the Fed,” speaks to the power of the US central bank to influence the markets. We certainly saw evidence of that when, in mid-May, Federal Reserve Chairman Ben Bernanke began alluding to “tapering” its massive and prolonged asset-buying program, sending many global markets into a tailspin. Fed policymakers have subsequently tried to calm fears that the liquidity rug would be pulled out from under the markets too fast, and too soon, including at the latest Fed Congressional testimony on July 17. Christopher Molumphy, CFA , chief investment officer of Franklin Templeton Fixed Income Group, shares his perspective on recent fixed income market ups and downs.
Molumphy observes that the rise in fixed-income market volatility over the past couple of months hasn’t seemed to be tied to much of a change in overall US economic fundamentals, so something more short-term, technical in nature seemed likely in play.
“When we look at economic growth, inflation, and the labor markets, the trends that have been in place for the past year if not longer are still generally in place. We think overall the fundamentals remain about as they have been, which is modest, below-trend growth of about 2%, inflation remaining benign, and a very gradual improvement in the labor markets.
“We spend a lot of time looking at the labor market and trends in employment, because employment is such a key driver of both the economy and Fed policy. The US has been creating about 200,000 jobs per month for nearly a year now. Having said that, while the unemployment rate has come down gradually, to 7.6% in June from 8.2% in July 2012, what’s interesting is that in the last couple of months, more people have been returning to the labor force. The participation rate is finally starting to kick back up. Although more people re-entering the labor force is a positive dynamic, it may take a while longer for the unemployment rate to move downward.”
Why is that point key? In Congressional testimony on July 17, Bernanke again emphasized the importance of the health of the labor market in its decision making process, stating that currently “the jobs situation is far from satisfactory, as the unemployment rate remains well above its longer-run normal level, and rates of underemployment and long-term unemployment are still much too high.“
Bernanke also stated that “if the outlook for employment were to become relatively less favorable, if inflation did not appear to be moving back toward 2%, or if financial conditions–which have tightened recently–were judged to be insufficiently accommodative to allow us to attain our mandated objectives, the current pace of purchases could be maintained for longer.”
In essence, tighter policy isn’t a done deal in the short term, or perhaps even longer term. Molumphy offers his view of why he doesn’t think the Fed will make any sudden moves.
“The Fed has specified the unemployment rate is the threshold they are looking at for future actions, in particular, at some point raising the Fed funds rate off the zero percent floor. Bernanke has said previously that unemployment needs to get down to 6.5% before the Fed will start even thinking about raising the Fed funds rate. That’s something to keep an eye on. It may well take a very long time to get down to 6.5%, a fact that we think has been lost a bit in the marketplace.”
Looking back at previous quantitative easing (QE) programs, Molumphy points out that typically they lasted for about a year; they were not meant to last forever. As such, the end to the Fed’s latest (third) round of quantitative easing known as “QE3” shouldn’t have come as such a shock to the markets. He talks about when he thinks it could start winding down.
“We think the Fed, which first announced the latest program last September, might reduce the pace of purchases by year end. If all goes well, we expect it will ultimately stop the purchases altogether sometime mid-next year. If it plays out like that, it would be a normal QE program, if a bit longer than usual. So, we see nothing inconsistent with the guidance that has been given regarding this latest round of QE.”
Looking ahead, Molumphy believes that Fed actions are going to continue to be data dependent.
“We can try to guess what the Fed is thinking, but ultimately the Fed is driven by inflation and the labor markets. With inflation seemingly under control, it’s really the labor markets that dominate. So if you want to know what the Fed’s going to be doing, look at the labor markets — how many jobs we create each month and, most importantly, the unemployment rate.
“In their last policy meeting (in June), 15 of the 19 Fed governors thought that the Fed would not start raising rates until sometime in 2015 or later. While the Fed funds rate is sitting at zero it’s difficult to see longer term Treasuries going significantly higher. We find it highly unlikely that we’ll see a significant additional increase in the 10-year Treasury over the next couple of quarters.”
In other words, perhaps investors shouldn’t be so quick to panic.
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