Investors Remain Cautious Ahead of December Fed Meeting

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Investors are preparing for a volatile week in advance of the Federal Reserve’s decision about whether to taper the pace of their $ 85 billion monthly bond purchases in the third round of the Fed’s quantitative easing program (QE3).

Some economists are expecting the Federal Reserve to begin tapering this week at the Fed’s December meeting which wraps up on Wednesday in Washington while others believe the Fed will wait to taper until January or March 2014 after more employment data is digested and inflation moves up higher from 1.2 percent, well below the Fed’s 2 percent target.

When the Federal Reserve started their QE3 program in September 2012, the stated goal of their monetary stimulus program was substantial improvement in labor market.

By most accounts, the Federal Reserve has already successfully achieved their stated goal of improving labor outcomes across the country despite the Fed’s balance sheet ballooning up to $3.994 trillion through its highly accommodative monetary policies.

The U.S. unemployment level has fallen from 7.8 percent in September 2012 to 7.0 percent in the last employment reading in November 2013, the lowest unemployment rate since November 2008.

Job growth has averaged 195,000 per month over the previous 12 months.

On December 6th the Department of Labor reported that the U.S. economy surpassed consensus estimates and added 203,000 non-farm payroll  jobs in November while the non-farm payroll employment data for September was revised from 163,000 to 175,000 and October’s data was revised from 204,000 to 200,000.

The labor force participation rate also moved slightly higher in November to 63 percent from 62.8 percent.

Progress in labor market outcomes since September 2012 provides the most compelling reason for tapering.

In June Fed Chairman Ben Bernanke spoke about the 7 percent unemployment rate threshold that is needed before the Federal Reserve will slow down the Fed’s pace of bond purchases.

Since the 7 percent threshold was reached last month, more economists now believe that the Federal Reserve won’t throw Fed Reserve Chairman Bernanke’s credibility into question and surprise the market once again as it did last September when they decided to not taper the pace of their bond purchases and cited some concerns about the impact of the fiscal drag on the economy.

Fiscal Drag

Last week, U.S. lawmakers in the House of Representatives approved a modest two year budget bill that prevents another government shutdown for two years, caps federal spending, and softens the impact of the next round of government sequester cuts in 2014 that was expected to cause fiscal drag on the U.S. economic recovery.

The budget bill is expected to be voted on this week in the Senate. The majority of political analysts believe that the bill will be approved before it is signed by President Obama, although some Republicans in the Senate such as Senator Rubio (R-Florida) and Ted Cruz (R-Tx) are opposing the bill.

The debt ceiling issue is also expected to come up again before the next deadline on Feb 7th.

On February 8, the debt limit will automatically reset to a higher level.

At that point the U.S. Treasury could be able to use “extraordinary measures,” the special accounting maneuvers that allow it to keep paying the country’s bills without surpassing the debt limit.

But the measures won’t last very long since the Congressional Budget Office estimates that those maneuvers would be exhausted by June.

Since the Fed started the QE3 program in September 2012, the overall global economy has strengthened mostly due to central bankers across the globe maintaining accommodative monetary stimulus actions to keep interest rates low, spur investment, and drive growth.

A tapering of the Fed’s $85 billion QE3 program ($45 billion in Treasury bonds and $40 billion in mortgage bonds) will represent a slow return to normalization with U.S. monetary policy but it won’t impact the Fed’s decision to stay on the accommodative track by keeping short term interest rates near zero.

The Fed has pledged to keep shorter term interest rates at 0 to 1/4 percent as long as the unemployment level remains above 6.5 percent and inflation does not rise above 2.5 percent.

However, Fed Chairman Ben Bernanke recently signaled that the Fed is unlikely to raise rates even after the 6.5 percent unemployment threshold is crossed.

In June Federal Reserve Chairman Ben Bernanke began to talk about the Federal Reserve possibly reducing the pace of their quantitative easing program (QE3) as the employment outlook showed real signs of improvement.

Bernanke’s ”taper talk” caused major ripples in the market and became one of the driving catalysts for the yield on the 10 yr. Treasury moving 1 percentage point higher in only 3 months (May-July), resulting in mortgage rates also jumping 1 percentage point and pressuring the  recovering housing market.

Currently, the yield on the 10 yr. Treasury remains at 2.86 percent and many economists believe that a tapering by the Fed could push yield near or above the 3.0 percent in the weeks ahead.

-Johnathan Schweitzer

 

 

 

 

 

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