By Terry Connelly
Ever since Fed Chairman Ben Bernanke offered the first hint of the Board’s potential “tapering” of purchasing monthly Treasury and mortgage-backed securities beginning sometime later this year in response to a Congressional questioner in late May, the financial markets have generally assumed that the tapering would begin at the Fed’s scheduled September 17-18 meeting. Perhaps, at least initially, this was due to the question being framed by the Congressman in terms of whether a cutback in purchases could start as early as September -- although Bernanke did not specifically endorse such a timetable (he said maybe “later this year,” subject to certain conditions), he didn’t rule out September, either.
The emergence of the “Septaper Assumption” (picked up by many Wall Street commentators and respected journalists) made a big difference in the market prices of both stocks (the Dow went down 600 points in just a couple days) and bonds (10-year US Treasuries showed a full 1% surge in their interest rate and a corresponding drop in prices). The treasury bonds continued to rise as high as 2.75% as Bernanke and several Fed members took to various podiums to suggest that the markets had overreacted. The Fed had clearly not intended to suggest that they thought interest rates should tighten to such a degree so quickly – after all, they had engaged in such “Quantitative Easing” bond purchases precisely to keep longer-term Treasury rates down to hold mortgage rates down and facilitate a continued housing value rebound: one of the conditions that had them thinking about cutting back on QE in the first place. A premature, aggressive spike in interest rates was the last thing Bernanke & Co. would want to occur.
A disconnected market
Part of the disconnect between the markets and the Fed was probably due to Bernanke seeming to make the decision on tapering depend upon the Fed’s “outlook” for the economy, employment and inflation. And sure enough, when the Fed announced at its June meeting that its outlook had improved, the markets saw a confirmation of the Septaper Assumption. The Fed increased its forecast for 2013 final GDP despite the sub 2% showings in Q1 and now expected for Q2 on the assumption that the Sequester effects would diminish post-September. They also lowered their consensus forecasts for unemployment from the end of this year on out to 2015 as start and local government increased their hiring along with businesses, and opined that current deflationary tendencies in the economy were probably due to transient factors (there was one dissent on this point).
The Fed Board also authorized the Chairman to even go so far as to outline a timetable for tapering that would see an end to the purchases by mid-2014 provided the economic results tracked the Fed’s forecasts to a lowering of unemployment rate of 7% by that time. While Bernanke again did not specifically say they would initiate a cutback in September but instead repeated that the tapering process would start “later this year,” markets again fell as they assumed September would be the trigger month. Interestingly, while Bernanke emphasized that QE tapering was not to be confused with literal monetary tightening, and that the Fed’s previous focus on a 6.5% unemployment figure was meant as a "threshold" not a "trigger" for increasing the short-term interest rates that is the Fed’s primary monetary tool for influencing the course of economic , he made no such proviso with respect to the 7% figure he specifically associated with the end of QE purchasing.
The September question
Taking the foot off the accelerator, per Bernanke, was not like stepping on the brakes. But the market participants read his remarks as though they were in a car with no brakes: easing the accelerator is indeed the next best thing to braking (or “tightening”) in that context! Both the stock and bond markets took another hit. Again, the Septaper Assumption was put back on the table, and mortgage rates shot up again.
Market commentators were also suggesting that the September trigger was really based on two factors the Fed wasn’t mentioning: (1) they were actually running out of mortgage-backed securities they could buy at the $40 billion per month clip without creating major dislocations in the functioning of that market, including the ability of traders to hedge their mortgage-related positions with Treasuries. (2) Bernanke was now virtually certain not to be reappointed to a third term commencing in January 2014, and he would want to have the QE “exit strategy” firmly in place before he left the Chair, rather than leaving to his successor the difficult and unprecedented task of engineering a soft landing.
Since the Fed has only two meetings left (September and December) where they are scheduled to announce revised forecasts and hold a post-meeting press conference, the feeling is that Bernanke would not wait till his last days to do the deed, even if the data on the Fed’s expected rise in second half GDP would be a lot clearer by then – so it must be September.
A dose of reality
But the rapid rise in mortgage rates has clearly spooked the Fed; Bernanke used a mid-July speech to subtly shift emphasis from an “outlook-dependent” trigger for tapering to a more actual “data-dependent” scenario where the numbers would have to match the forecast. He also emphasized that extraordinary monetary accommodation would still be called for by the level of uncertainty in the economy which could undermine the Fed’s rosier forecasts. In response, the Dow jumped to a new all time high, and held on during Bernanke’s latest Congressional testimony, where he took pains to break no new ground. And said the mortgage rate rise was "unwelcome." But the Septaper Asssumption still holds sway in the bond market, with rates holding around 2.50 for the 10-year, which doesn’t help the mortgage market. What’s a Fed to do?
Maybe a dose of data-dates reality will help alleviate the bond fever: Q2 GDP will be out at the end of July and likely will show an economy growing slower that even the anemic 1.8% for Q1. Despite 200K in job growth since September, unemployment seems stuck at 7.65. We’ll get July and August figures before the Fed’s September meeting, but even further 200,000 new jobs may not notch unemployment down as more return to the work force or just go part-time. Corporations announcing Q2 earning are lowering, not raising, their forecasts for growth the rest of the year, contrary to the Fed’s forecasts, which would require almost 3% GDP growth in the next two quarters to reach their 2013 target.
The Fed will of course have some educated guesses from economists by mid-September about Q3 GDP, but won’t have the actual first estimate until October 30, which just happens to coincide with the last day of its regularly scheduled meeting that month. Could they not put off the decision to that day to get more clarity? What’s to stop them and Bernanke from simply adding an explanatory press conference? The markets should consider an “October Surprise” at least as likely as “Septaper,” and maybe more so.
Terry Connelly is an economic expert and dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore, global chief of staff at Salomon Brothers investment banking firm and global head of investment banking at Cowen & Company. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education.