Fed Tapering is not Tightening
The FOMC decides this week whether to begin slowing its purchases of U.S. Treasurys. Concerns of a premature tightening in liquidity conditions have upset global bonds markets, and spread havoc in parts of the emerging world, especially in those countries with current account deficits. We expect investors to soon calm as they realize that an actual tightening in Fed policy is a long way in the future, and will lag the still modest revival in economic growth.
A slowdown in Fed bond purchases will mark the peak of the reflationary era. However, the Fed’s balance sheet will still expand until mid-2014, underscoring that policy will remain very expansionary. Moreover, by tying future rate hikes to employment conditions, the Fed has signaled that it will lag the business cycle, and will stay accommodative for a long time.
By most metrics, monetary policy in the major countries has been unusually pro-growth. For instance, despite the most anemic economic recovery in the post-WWII period, the gap between nominal GDP growth and policy rates in the G7 countries is at its most positive level in many decades, excluding a brief period when growth rebounded after the Great Recession in 2009-2010. Meaningful growth slowdowns and recessions occur whenever the gap has been depressed or has fallen rapidly. Policymakers are determined to spur growth, given the deflationary risks and huge fiscal challenges. Thus, the gap between growth and policy rates will stay historically wide, i.e. will remain very supportive of growth.
Fears that the Fed could lose “control” of the bond market because of a dearth of buyers, thereby causing bond yields to soar further, are overblown (although such sentiment typically develops during bond bear markets). The supply of new Treasurys will slow markedly as the budget deficit narrows, and foreign central banks will persist in purchasing U.S. government paper in order to suppress their currencies. Importantly, the moderate pace of economic growth and continued below-target inflation are consistent with only a mild uptrend in bond yields now that the period of extreme overvaluation is over.
In sum, while we remain bearish on bonds, the slope of the rise in yields should be mild in the next year compared with recent months. U.S. and global monetary policy will still be very pro-growth for the foreseeable future, which is positive for equities.
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Warren C. Smith, MRB – The Macro Research Board