Month in Cash: We can't get too mad at the Fed
We along with many others were as much befuddled as we were disappointed when Fed policymakers decided to put off tapering in September. We had expected a minimal pullback in the central bank’s $85 billion in monthly purchases—enough to likely nudge up rates along the cash-yield curve as supply got reintroduced into the marketplace and the market began to price in the prospect for higher rates down the road. The Fed had been telegraphing tapering for much of the summer and the economic data—including that which was laid out by the policy-setting Federal Open Market Committee itself in its post-meeting statement and projections—seemed to justify such a move. Perhaps politics (concerns over how the next act in the ongoing Washington debt-ceiling/fiscal drama will play out) and successorship issues (Chairman Ben Bernanke is set to step down in January and the jockeying for his post—historically a muted affair—has been rather public) got in the way.
Whatever the reason, the lack of action by the Fed definitely has put a bit more downward pressure on short rates and repos in particular. The good news, however, is that even as it put off pulling back, the Fed went forward with its test of overnight reverse repos, which it plans to use to manage the central bank’s exit from the extraordinary monetary accommodation of the past five years. While the program won’t get started in full until tapering is done—and it now looks like that may not be completed until the latter stages of 2014—the availability of the overnight repos at rates set by the Fed have helped to establish a floor, nudging them up from still very low levels. This test, under which we’ve been able to purchase around $500 million daily and significantly more than that on some days, is set to run through January. So what the Fed didn’t giveth with one hand, it did giveth with the other. At the least, the two forces—no tapering but reverse overnight repos—are offsetting each other and helping prevent rates from slipping lower.
Lower for a little longer
Still, the reality is the Fed’s inaction means short-term rates are going to stay lower for a little longer. The lack of movement at the Sept. 17-18 FOMC meeting should serve to lengthen the time frame on what I call Phase 1, Phase 2 and Phase 3 of the unwind process. Phase 1 is the stage in which the Fed starts to stop and eventually ends quantitative easing by paring the $85 billion in monthly Treasury and agency mortgage-backed security purchases—the so-called tapering phase. Many thought that would start this month. Phase 2 represents the portion in which the Fed launches it reverse overnight repo program in earnest to help shed the more than $3 trillion added to its balance sheet through QE and other extraordinary measures since the global financial crisis’s onset. This program can’t get fully underway until Phase 1 is done. Phase 3 represents actual tightening itself, i.e., increases in the target funds rate. It doesn’t look like that will happen until late 2014-early 2015 at the earliest.
It’s not clear what may happen when a new chairman comes in, but it’s worth noting the presumed front-runner now that the more hawkish Lawrence Summers has pulled his named from consideration is Janet Yellen, who firmly is aligned with the Fed’s more dovish faction. While rates currently are being Fed-driven, on economic fundamentals alone, the case of higher rates is building. Growth is moderate and appears to be accelerating, housing’s recovery continues even though summer’s spike in mortgage rates appears to have slowed the momentum somewhat, and job growth has been modest but is entering the period—fall and winter—when the biggest payroll gains have come the past three years. So we still see some light at the end of the tunnel—the bias is for short rates to begin to move up and for the cash curve to steepen. It’s just that the moves won’t come as early as we were thinking a month ago.