Friday, September 20, 2013

“What I like best is nothing.” – A.A. Milne, The House at Pooh Corner

Yesterday, the Federal Reserve borrowed a page from the Winnie the Pooh series and did nothing.
That is, they decided that tapering, or buying less Treasuries and mortgaged backed securities in the Open Market, was not in the best interest of the US economy at this time. What was very entertaining, if you are a market participant, was the long and complicated explanation about the nothing it was doing. It appears that doing nothing requires an inordinate amount of explaining! One reason the Fed gave for doing nothing was that the economy continues to have some challenges and, therefore, it was best to do nothing rather than something. Actually, they did do something; reduce projected economic growth from a range of 2.3% to 2.6% to just 2.0% to 2.3%. They also reduced their forecast for unemployment from a range of 7.2% to 7.3% to 7.1% to 7.3%, an economic positive. This is somewhat befuddling, since typically lower economic growth does not translate to a lower unemployment rate, but then this is the ‘new normal’. It appears that more printing of greenbacks, or digitizing, is the new method of creating economic growth and jobs. Count us among the skeptics.

Concerning the labor market, the Fed Chairman did point out that the Fed is concerned about the drop in the participation rate, noting that unemployment is currently understating the level of employment. Mr. Bernanke did explain that the aging population is one of the reasons for the decline in the participation rate. However, while he is correct, since that is always the case, what he did not explain is why the 25 to 55 year old demographic is also leaving the labor force. For a Federal Reserve that promised to be more transparent, we are sure left with more questions today than answers. After all, if QE3 had worked, should not the economy be doing better? And if it did not work, then why continue with QE3? The markets, at least the bond market for certain, had already taken into consideration some tapering this month and thereafter. Why reverse this process? “Heaven knows, Mr. Allison.”

The markets took all of this “nothing” very well, rallying right after the announcement. (Well, gold actually began its move three minutes before the announcement.) Following this initial reaction, most of the markets calmed down a bit. In fact, the long end of the fixed income market has given back more than half of its initial move. Although this may be a temporary respite, we suspect that the long-end of the bond market is not ‘buying’ the Fed nothingness. We could be wrong and the market could rally tomorrow, but let’s be realistic, although rates will remain low for a long period of time, it is the short-end of the market that is chained to this future. The long end recognizes that someday the Fed will discontinue their purchases of long-dated Treasury securities and then we, the US, will have to find another buyer. But who would buy long-dated bonds if the Fed will not support the price anymore? A steeper curve is in the making!

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