The Fed
In a somewhat surprise move, the Federal Reserve (Fed) finally decided to start gradually reducing its quantitative stimulus program last month. The Fed decided to reduce both purchases of mortgage-backed securities and Treasuries by $5 billion per month each. The Fed emphasized that tapering does not mean “tightening.” The Fed also extended its commitment to keep short-term interest rates “exceptionally low” until either the unemployment rate declines to 6.5% or the inflation rate climbs above 2.5%.
Yield Curve
The U.S. Treasury yield curve steepened again last month on improving economic data and Fed tapering expectations. The yield spread between the 3mo-Tbill and 5-year Tsy climbed 0.36% while the 2-year and 5-year spread widened by 0.27%.
The Fed’s forward rate guidance remains dovish despite its latest tapering announcement. Of the 17 voting and non-voting FOMC members,15 do not expect a hike until after year-end 2014. 12 of those 15 members see the first hike coming sometime in 2015, while the other three do not expect a tightening until 2016.
Interesting Observation
Bear Flattener – As the Fed continues to taper going forward the shape of the yield curve will garner more attention. After the surprise announcement, the intermediate area of the curve increased greater than the long-end (bear flattener). This phenomena is likely to continue as more stimulus is removed and as short rates remain anchored.
Monthly Wrap-up
The FOMC finally decided to begin the tapering process, one that many believe should have started back in September. Several factors most likely weighed on their decision: the belief that the benefits of QE were eroding as time passed; the presumption that the economic risks are now “more nearly balanced” rather than tilted to the downside; the benefit of having several months of reasonable job growth; the help of diminishing fiscal austerity with a less volatile political climate; and, the assistance of a less inflated Fed balance sheet.
The FOMC also indicated that tapering will only continue in further measured steps at future meetings if economic data are consistent with its expectations. The Fed’s decisions about the pace of the tapering will remain dependent on its outlook for the labor market and inflation.
On average, economic data surprised to the upside last month as the recovery continues. Third quarter GDP was revised upward to 4.1%, its highest level since 2011. Strong manufacturing, resilient equity markets and ongoing building confidence offer encouraging signs as we transition into 2014.
