Misreading the Fed
So, when economists drew up their 2014 forecasts in the final two weeks of December, and shortly after the Fed announced the onset of its withdrawal from the bond markets, the consensus view was that bond yields would end this year at 3.47%. In light of the Fed’s action, bond selling accelerated as 2013 came to a close, driving the 10-year yield substantially higher and closing at 3.03%. How could Wall Street call the widely-watched Treasury market so spectacularly wrong?
Economists and bond bears misunderstood what the Fed was doing as it started the process of tapering. Some traders assumed that the Fed was on the brink of tightening policy or that tapering itself was a form of tightening. They thought the Fed would step back from leaning on the yield curve and then start lifting the short-term Fed funds rate. That was never the Fed’s intention and then two things happened. First, the Federal Open Market Committee stated that further additional tapering was fully data dependent.
Second, investors failed to build in the effect of higher bond yields in response to Fed tapering. Rising yields in direct response to fears and the actual tapering process affected confidence and decision making. Investors are poor at building such yield shifts into their reaction functions. One could argue that the Fed might be less likely to temporarily cease tapering precisely because rising slow progress.
Growth in the U.S economy shrank in the first three months of the year for the first time in three years, although much of the contraction was likely due to poor weather. Nevertheless, the development of the business cycle seems different this time—in keeping with the “new normal” mantra. Investors assumed that if the Fed was at the point of tapering, the economy would be rebounding. True, but not to the same extent it has in any other recovery. Consumer spending remains robust, yet wages are stagnant and the pre-crisis economic engine of home-construction is a faint shadow of its former self.
The financial crisis has left its hallmark on the rest of the world. While the ensuing Eurozone financial crisis appears over, at the start of June the European Central Bank (ECB) had finally relaxed policy in response to weak consumer price pressures, coupled with a lack of economic traction outside of the German manufacturing powerhouse. China continued to serve up deep-rooted concerns over its growth trajectory as the real estate market falters, while Japan has only stabilized as a result of massive monetary measures from its central bank. Global growth is hardly accelerating, and much of the developed world is on watch for further slowdown while inflationary pressures remain muted.
Some onlookers note that perhaps U.S. government bond prices recently accelerated, sending yields plunging, because of their relative value as Eurozone government equivalents rallied in preparation for the ECB’s latest monetary ease. Part of this argument may be true. Yes, the odds are that the Eurozone financial crisis has been resigned to history, which explains why even peripheral Spanish, Italian and even Portuguese yields compressed massively to Germany’s bunds during May. And you can hardly blame investors wanting to own bunds ahead of the widely-predicted ECB easing in June given that the move was supported by the Bundesbank, whose members are more concerned about the specter of deflation rather than inflation at this stage of the recovery.
Yellen stumbles out of gate
Fed Chair Janet Yellen has recovered from a stumble in her maiden FOMC press conference in which she indicated that the distance between the end of taper and the onset of the take-off for the fed funds rate might be six months. She continues to point to the reality that the Fed may change course if the data dictates, and recognizes that the labor market has internal deficiencies regardless of the headline unemployment rate. It is perhaps this recovery from her rookie appearance that has had the greatest influence on the performance of stocks and bonds this year. The key point to note is that when forecasters were busy at the end of 2013 factoring in the expected performance of hard economic data, they failed to project the rollout of Fed-speak, which itself is a function of markets’ response to Fed action and the behavior of economic data.
Bond buyers have also begun to recognize that even as unemployment falls, there is little inflation. Also, judging by several of the measures Yellen points to, there is little chance of a build-up in wage pressures—the typical source of wage-push inflation. This is just dawning as investors conclude that the inflation genie remains firmly in the bottle despite vociferous criticism of the Fed for risking its appearance in its untested asset purchase program.
Very few people actually understood the mechanics of quantitative easing, mistaking former Fed Chairman Bernanke’s explanation of the “portfolio balance channel” with increasing the money supply. If you raise the supply of money, surely economic theory states that prices must increase! That has not happened, and even as the Fed sounded cautious over the size of its balance sheet, its agents could see few signs of frothy asset markets.