1 market insightsFed-watching: When Will Bernanke & Co.End Bond Binge, Boost Interest Rates?nsightsMarketMarket participants of all types have been forced tobecome “Fed watchers.”The original meaning of theterm referred to one or two people at financial firms whowatched for any Federal Reserve actions diligently andconsistently kept up with all communications comingfrom the central bank in the hope of garnering someadditional knowledge as to future monetary policy.Given the state of affairs post-2008 – including ahistorically low federal funds rate, the Fed’s massivebalance sheet and the current round of asset purchases— Fed-watching is the task du jour for every marketparticipant around the globe.The steady, if not stellar, economic performance ofthe US economy has created an environment in whichthe Fed’s focus is slowly shifting. What is currentlyconfusing Fed watchers is the timing of three critical Feddecisions: • First, when does the Fed end its asset purchases? • Second, when will the Fed commence raising itstarget federal funds rate and abandon its zero ratepolicy? • And third, will the Fed decide to sell some of its USTreasury and mortgage-backed securities, or will ithold them to maturity?We will tackle these timing questions in the order wethink they will occur. We note that the Fed has indicatedthese are independent decisions that may be based ondifferent criteria. While that may be case in the minds ofsome members of the Federal Open Market Committee(FOMC), our own perspective is that all of these timingdecisions are so intertwined with the progress of theeconomy that they must be analyzed as a package,even if the decisions are technically made separately,with potentially long time lags in between.When will the Fed stop buying assets?The Fed’s current asset purchases involve $40 billion amonth in mortgage-backed securities (MBS) or relatedagency debt and $45 billion a month in long-dated USTreasury securities. At this rate of purchasing, the Fed’sbalance sheet will have expanded by about $1 trillionduring 2013, to approximately $4 trillion by the end ofthe year.Many members of the FOMC view this asset-buyingprogram as a form of extra insurance to make sure thatthe US labor market can continue to create jobs in theface of the fiscal constraint implied by the modestlyhigher taxes in the New Year’s Day tax compromiseand the spending sequester that has been allowed togo into effect. Consequently, the continuation of thisasset-buying program is contingent, in part, on how theeconomy performs through the course of the year.In addition, there is possibly a legacy perspective atwork as well. Fed Chairman Ben Bernanke has indicatedhe will not seek reappointment when his tenure aschairman ends in January 2014. It will have been fiveyears after the financial disaster in 2008, and endingApril 10, 2013By Blu Putnam Samantha Azzarello,Chief Economist Economist, CME Group
April 10, 20132 market insightsthe asset-buying programs may well allow Bernanke totake a victory lap, in the sense that he will be turning thegavel over to a new person, having made some progressin putting the central bank back on the road to a morenormal conduct of monetary policy.In any case, the central question for the Fed will revolvearound continued progress in the economy andspecifically job creation. Our analysis of the US labormarket suggests sufficiently steady improvement tokeep the unemployment rate on a downward path.There are some nuances related to this relativelypositive labor market projection. In particular, weanticipate a bumpy ride. There is a likelihood of aslowing of the pace of job creation over the spring andsummer due partly to seasonal effects that are notproperly captured in the Bureau of Labor Statisticsdata-smoothing approach.1Also, some modest impact from budget austerity ishighly likely, and probably helps explain the decelerationof job creation in March compared to January andFebruary. Even with our seasonal caveat, the reality offiscal austerity, and the weak March data, private sectornet new job formation may bounce between 125,000 to175,000 per month for the rest of 20132. But the privatesector has not been the problem over the last few years.During the Great Recession, government entities at alllevels – federal, state and local – found itself with toomany expenses and not enough revenue. State andlocal governments have shed over 800,000 jobs sincespring 2009 to address their budget challenges. For2013, government job losses at the state and local levelappear to be slowing.An unexpected shift back into recession would derailour projections. Even if we are a little too optimisticon net job creation, however, we believe that averagemonthly net job gains in the low to mid 100,000s areall that is required to keep the unemployment ratedrifting slowly lower, given the deceleration in USlabor force growth to below 1% annually as thepopulation has aged.We think that progress on the job creation frontwill still disappoint many FOMC members, even asthe unemployment rate drifts lower. Many FOMCmembers are expecting more rapid cyclical growth inthe labor force than we assume, and hence declinesin the unemployment rate that are partly attributed tomovements in the denominator (labor force) are notwell-received.Nevertheless, a continued decline in the unemploymentrate may make it possible for a consensus to form onthe FOMC that asset purchases can be gradually slowedover the last part of 2013 and eventually halted duringthe first quarter of 2014.This would appease those FOMCmembers worried about the long-run risks of a bloatedbalance sheet. It also would enable Bernanke to turn overthe gavel with one decision made, allowing the new Fedleader to focus on the next decision concerning how longto keep the zero federal funds rate policy in place.1See our previous report which covers the difficulties in seasonal adjustment in some detail. Blu Putnam and Samantha Azzarello, U.SUnemployment May Dip Below 7% Before End of 2013, CMEGROUP.COM (February 4, 2013), http://www.cmegroup.com/education/files/blu-us-unemployment-poised-to-dip-below-7-percent.pdf2For the details of our in-depth current US economic outlook, please refer to our report: Blu Putnam and Samantha Azzarello, U.S. EconomicUpdate: A Robust Private Sector Despite Long-term Policy Risks, CMEGROUP.COM (March 26, 2013), http://www.cmegroup.com/education/files/housing-energy-bolster-us-economys-prospects.pdf
April 10, 20133 market insightsWhen will the Fed begin raising theFederal Funds Rate?The Fed explicitly has tied its federal funds rate forwardguidance to the labor market. In December, the Fed seta threshold unemployment rate of 6.5% (it was 7.6% inMarch). The distinction needs to be emphasized thatthis unemployment rate target is not a trigger — it isa threshold upon which the Fed will start to considerraising the federal funds rate.Our forecasts suggest that a 6.5% unemployment ratemight be achieved as early as summer 2014. Our view,however, is that passing through the 6.5% unemploymentrate threshold will not be a sufficient condition for the Fedto be ready to raise its target federal funds rate. The Fedmay delay commencing the process of raising thefederal funds rate until inflationary pressures emergeand the core Personal Consumption Expenditure(PCE) index is rising faster than 2.5% to 3%, with adiscernible upward trend.That is, the Fed has a clearly stated dual mandate –encouraging both full employment and price stability.The unemployment rate target of 6.5% only addressesone half of the Fed’s dual mandate.Moreover, a lack of attention to the dangers of deflationhas been a prominent criticism by academic scholarsconcerning the Fed’s management of monetary policyduring the Great Depression of the 1930s. The lengthand depth of the Great Depression are partly attributedto the failure of the Fed to take adequate measures tostop price deflation. Similarly, many scholars, includingProfessor Bernanke, when he was on the faculty atPrinceton University, have chided the Bank of Japanfor allowing a psychology of price deflation to becomeembedded in the economy3.Hence, Bernanke has increasingly made it clear thathe treats the objective of avoiding deflation just asimportantly as the objective of encouraging decliningunemployment. And, it is probably worrying to the Fedthat no inflation pressures have developed, despitean extended period of a zero federal funds rate andmassive quantitative easing.US inflation as measured by the general Consumer PriceIndex was about 2% in February (versus the same monthin 2012), while the core inflation rate, as measured byPCE price index excluding food and energy, stands atabout 1.25% over the same period. Furthermore, not onlyare there no inflation pressures in sight, but international3For Bernanke’s criticisms of Japan’s Policy, see Ben S. Bernanke, Japanese Monetary Policy: A Case of Self-Induced Paralysis?, Presentationfor ASSA Meetings in Boston, MA, January 9, 2000.
April 10, 20134 market insightscompetition and the relative stability of the US dollarsuggest that inflation pressures may not emerge until2015 or beyond. This inflation outlook means the Fedcould maintain a zero federal funds rate into 2016,possibly long after the unemployment rate hasdeclined below the 6.5% threshold.When will the Fed start selling assets?Given the composition of the Fed’s balance sheet andthe pace of asset purchases that we anticipate throughthe end of 2013 or early 2014, the Fed may own asmuch as $2.2 trillion in US Treasuries and $1.3 trillionin MBS, and possibly more, by the time it calls a halt toits asset purchase program. The Fed probably needsonly $1 trillion to $1.5 trillion of assets to manage thebanking system under the current structure of reserverequirements and bank regulation. If so, that wouldleave an excess of $2.5 trillion to $3 trillion of unneededassets on the Fed’s balance sheet. These additionalassets will be matched by $2.5 trillion to $3 trillion ofexcess reserves in the US banking system, representingliabilities on which the Fed will pay interest.Hence, a key question for markets is when the Fedwill start selling off parts of its massive balancesheet. The answer may be never. While the Fed hasspoken before of plans to unwind, its balance sheet,it might decide not to do that, choosing instead tohold its assets until maturity.There are compelling reasons for this. First, while Fedpurchases of MBS may or may not have provided a boostto the housing sector, massive MBS sales might disturb astill-fragile sector of the economy.The mortgage-buyingand packaging agencies, Fannie Mae and Freddie Mac,have recently returned to profitability, but they are stillunder intense federal regulatory pressure to streamlineoperations.While they are being reformed, the Fed maywant to avoid creating additional complications.Similarly, the Fed may also want to avoid destabilizingthe US Treasury securities market. The breakdownof ownership of US Treasury debt shows that the Fedowns 10% of all outstanding issuance. But that reallyunderstates the Fed’s influence on the tradable market.Foreign official accounts and US government trustaccounts, which together own half of all Treasuries, arenot actively traded. These are buy-and-hold investors.Thus, the Fed effectively has influence over one-fifth ofthe Treasury market that is traded, such that any sellingprogram holds the potential to destabilize the market.The directional implications are straightforward, if theFed became a big seller, then there is the potential forprices of US Treasuries to go down and yields could rise.There are other less obvious implications for financialrisk managers that a program of Fed Treasury sales couldengender. First, there would be reasonable likelihood of anincrease in market volatility. Even if the Fed decided to betotally transparent and detailed about any selling program,faced with both new issuance from the on-going budgetdeficits and the Fed selling Treasury securities, marketparticipants might well become more than a little jitteryabout how price dynamics would be impacted.GovernmentTrusts, 30%Fed, 10%ForeignOfficialAccounts,20%Other PublicMarketParticipants,40%Percent of US Government Debt Held by VariousTypes of EntitiesSource: US Treasury for Gross Government Debt and Intergovernmental Trust Holdings, Federal ReserveH.4.1 release for Fedearal Reserve Treasury Security Holdings and Foreign Official Acocunt Holdings.
April 10, 20135 market insightsSecondly, and extending this line of thought, theprobability of price jumps might also move upward dueto the sheer volume of new issuance and potential salesfrom the Fed. Both a higher probability of discreet pricejumps and shifts in the volatility environment wouldmake less robust any risk management model thatembeds an assumption of price continuity and stablevolatility, as almost all of them do.When we put all this together, we think the Fedmay choose to delay sales of its Treasury securityportfolio for a very long time. That is, our conclusionis that both MBS and US Treasury security sales areunlikely. In a rising rate environment, should one develop,these decisions would have far-reaching implications forthe Fed’s net earnings and remittances to the US Treasury.If the Fed does not sell assets, it is effectively choosingto let them mature, which could take decades. Weshould point out that during the long period that wouldbe required for assets to run off at maturity, the Fedwould need to pay rising funding costs, in the formof higher rates on excess reserves, as noted earlier. Itmight also have to book unrealized capital losses (ifbond yields rise) as a charge against net earnings4. Thiswould imply the Fed would no longer make contributionsto deficit reduction from its net earnings, as it has in therecent past.Market Implications from the Fed’sTiming DecisionsIn anticipation of the Fed ending asset purchases at theend of 2013 or early in 2014, our judgment is that thelargest market impact will occur in long-dated Treasurysecurities, because that has been where the bulk of Fedbuying has occurred, and because persistent budgetdeficits will require continued net new issuance. Withoutthe Fed to purchase a major portion of Treasury net newdebt, there is an increased likelihood of rising yields inTreasury bonds and notes, higher price volatility, andgreater propensity for large discrete price movements.We would note that futures are an excellent riskmanagement tool for such directional uncertainties.The additional possibility of vega risk (that is,changes in market volatility) and outsized pricejumps also suggests that many market participantswill consider using options as part of their riskmanagement tool kit to manage the complexchallenges that may be posed by termination of theFed’s asset purchase programs.As attention shifts, probably in late in 2014 or 2015,to the timing of a move in the FOMC’s target for thefederal funds rate, we expect market participants willdramatically increase their scrutiny of US inflation data.Put another way, if we are correct that the Fed will usedual criteria for the decision to commence raising rates,then the mid-month inflation data releases may startto rival the first-Friday-of-the-month employment datareleases in garnering market attention. Also, while long-dated Treasury yields curve may be most affectedby the end of the Fed’s asset-purchase programs,the LIBOR curve is likely to bear the impact of anyrate decision.4For more in depth look of Fed accounting which also covers the Fed’s future earnings under various rate scenarios, see Seth B. Carpenter, JaneE. Ihrig, Elizabeth C. Klee, Daniel W. Quinn Alexander H. Boote, The Fed’s Balance Sheet and Earnings: A Primer and Projections, (Fed Board.,Financial Economic Discussion Series, Working Paper No. 2013-01, 2013).