by Brad Houle, CFA
Senior Vice President
In a surprising announcement on Wednesday, Federal Reserve Chairman Ben Bernanke said that the Fed will not be tapering bond purchases this month. He indicated that the $85 billion per month of bond purchases by the Fed in an attempt to stimulate the economy will continue until further notice. Financial markets have been in a tizzy about the tapering of bond purchases since May when the Fed Chairman first suggested that the pace of purchasing would decline. Interest rates climbed following this announcement, which impacted rate sensitive stocks, emerging markets and mortgage refinancing activity.
The Fed was most likely displeased with the increase in interest rates that accompanied the first indication of tapering. To counteract the rise in rates the Fed decided not to taper purchases to drive rates back down. Treasury rates had increased about 1 percent from May to the recent peak. Mortgage rates also climbed a similar amount from 3.5 percent for a 30 year fixed rate mortgage to about 4.5 percent today. This change dramatically slowed mortgage refinancing activity and caused a slowing in the velocity of the housing recovery. As a result of the slowing in refinancing activity, in some cases the banking industry has begun laying off employees involved in mortgage refinancing. Purchase mortgage applications have dropped off dramatically since the initial May announcement.
In actuality, nothing has really changed relative to Fed strategy. Bernanke said, “If the data confirms our basic outlook” for growth and the labor market, “then we could begin later this year.” There are only two more Fed meetings in 2013, one on October 29th and one on December 17th. In all likelihood, the tapering announcement will probably come at the December meeting unless there is a dramatic tick downward in economic data.
It has long been our assertion that the Fed will begin tapering for the right reasons. Looking past the wiggles in monthly economic data, the economy is improving. Employment is making gains, however lumpy the job creation might be. Capacity utilization has rebounded nicely and is moving in the right direction without being inflationary. Also, consumer confidence and auto sales have been strong.
We continue to believe that the economy will be stronger in the second half of this year and the recovery is intact.
Takeaways:
- A rare surprise announcement by the Bernanke Fed is really not a shift in Fed policy
- The brewing debt ceiling battle is shaping up to be contentious and will inject volatility into the markets. This topic will most likely dominate financial news for the next two weeks