The Fed Blinks

Mr. Bernanke and his Federal Open Market Committee surprised markets this week by declining to begin tapering their monthly purchases of $45 billion in US Treasuries and $40 billion in mortgage bonds. St. Louis Fed President James Bullard said markets
shouldn’t have been surprised by the decision because the FOMC members have repeatedly said the decision to slow, or taper, would be “data dependent.” A nearly 1.5% jump in stocks on top of the no-go Syria rally of nearly 5% definitely implies surprise.

While much of the latest economic data is showing some improvement, in the Fed’s view the recovery remains far too anemic to begin removing the monetary support of QE3. In his Wednesday remarks Bernanke indicated concern that recent higher rates may have negatively impacted housing and fiscal drags from a stalemated Congress continue to weigh on the economy.

Rates on 30-year mortgages reached 4.93% percent in the week ended September 6th, which was the highest since April 2011 and up from a record low 3.57% in December, according to Mortgage Bankers Association data. The National Association of Realtors reported that sales of previously owned US homes unexpectedly rose in August to the highest level in more than six years, possibly as buyers rushed to lock in rates before they rose further.

Deep political divisions in Washington imply that the fiscal drag of sequestration’s nearly a trillion dollars in federal cuts in spending will continue. Compounding the uncertainty is the looming debate over the debt ceiling. Republicans are tying their support for more spending to the elimination of Obamacare and cuts in entitlement spending. Democrats seem closed to negotiations on either subject.

Other more basic economic indicators this week showed improvement in the economy. The Conference Board’s index of leading indicators was unexpectedly and sharply higher rising 0.7% in August. That followed a solid gain of 0.5% in July. A report on industrial production rose 0.4% in August and manufacturing jumped 0.7% (following a decline of 0.4% in July).

US Treasuries saw their biggest weekly gains in two months as market traders reduced their bets that rates would rise anytime soon due to Fed tapering. James Bullard said that when the Fed did begin tapering, the reductions would be “small” and Fed Chair Bernanke said on Wednesday that the job market is still far from what he would like to see. On those comments Treasuries bounced nearly 2%.

The stock market is up nearly 28.5% since mid November of 2012, not counting dividends. The 7-10 year Treasury is down 7.3% during the same period, not counting interest of 1.7%.

The rise in stocks is largely due to the Fed’s money-printing and near-zero interest rate policies, and less so the slowly improving economy. The Fed has overtly manipulated both the stock and Treasury markets with their monetary policy. We can only wait to see what impact the commencement of their tapering will be on both asset classes in the coming months. But it seems apparent that Treasuries better reflect that approaching reality than do stocks.