Ben Bernanke, who first discussed tapering with Congress late in May and more publicly in his 6/19/13 taper-timing press conference, has done some back-tracking on the need for and potential timing of reduced bond purchases. Consequently, the Fed's message on tapering has gotten very muddled.
The market is in silly season, sometimes rallying on weak data (July retail sales, business inventories, and NAR home sales) and other times rallying on strong numbers, most notably payrolls. The to-and-fro implausibly suggests that investors may now be calibrating the Fed's policy implementation down to the day. Economists are not so equivocal; the majority now assume tapering will start in September, according to Bloomberg, with an initial $10 billion whack per month both to Treasury purchases and CDO purchases. Argus expects the first $20 billion in monthly purchase reductions to be focused in the Treasury market.
Based both on official comments and common sense, we would expect the Fed to exercise fluidity in its program to end QE. We could see monthly bond purchases fluctuate month to month. In our view, Federal Reserve purchases of mortgage-backed securities could carry on for years. At the same time, we expect the Fed to fully cease open-market purchases of Treasury notes and bonds by mid-2014.
For the near-term, stocks may be subject to some profit-taking, in our view. The 10-day rolling average of advancers vs. decliners is in the upper 700s on the Nasdaq and in the upper 500s on the NYSE. We saw similarly elevated levels in mid-May and mid-February. In both instances, the S&P 500 sold off into month-end in May and February. With trading volumes thin and the latest bull leg showing little conviction, we would not be surprised if stocks weakened into the July month-end.
Private Economy Growth Supports Tapering QE
Despite the confusing signals issuing from the Federal Reserve's chairman and governors, we believe the Fed internally is devoted to ending QE -- and beginning that program this year. The domestic economy is showing increasing signs of recovery and expansion to support a less-accommodative policy. Based on trends in the consumer and industrial economy (and particularly in employment), we think the first elements of tapering could be initiated as soon as September 2013.
We have pointed out that this stock market recovery has been among the most unloved ever, at least partly because this recovery has been seen as the most suspect ever. Official BEA data shows that U.S. GDP grew 1.8% in 2011 and 2.2% in 2012. Those are not great numbers. But as Argus Chief Investment Strategist Peter Canelo points out, the private economy has been growing at 3%-plus for the past two years.
In current dollars, U.S. GDP was $15.68 billion in 2012, compared with $15.32 billion in 2011. If we back out government spending from both years (essentially flat around $3.06 billion), however, growth in remaining GDP was 2.83% in current dollars for 2012. If we use GDP expressed in chained 2005 dollars, which is how the BEA presents the data and how GDP growth is typically analyzed, U.S. GDP was $13.59 billion in 2012 compared with $13.30 billion in 2011. If we back out government spending from both years, growth in remaining GDP was 2.91% for 2012.
Isn't it disingenuous to back out the government from the GDP growth equation, given that the government must be counted in the overall measurement of domestic economic activity? GDP-less government activity does give some sense of the improving vigor in the private sector. Equally important, with the sequester in place and tax revenues improving at the local, state, and federal levels, we believe government spending will begin to stabilize around current post-sequester levels. Government may not be additive to the GDP equation anytime soon, but it could stop being a deep negative.
In previous notes, we have highlighted a raft of economic data -- on housing, automotive, consumer sentiment, consumer spending, industrial activity and capacity utilization, and more -- that supports the view of an expanding domestic economy. It is worth remembering that while QE was aimed at broadly invigorating the economy, the Fed measures QE's success by analyzing the unemployment rate. The Fed believes QE will have fully served its goals and will thus be unnecessary once the U.S. unemployment rate moves sustainably below 6.5%. Based on job-creation trends, we think the Fed will reach its unemployment target range by mid-2014.
For the past 12 months, the official jobs measure -- U.S. nonfarm payrolls -- has averaged a gain of 191,100 on a total basis and 196,400 on a private-sector basis. One year ago, the unemployment rate was 8.2%; it has since come down by 60 basis points, to 7.6%. The improving jobs situation is likely luring more long-term unemployed back into the labor force; that tends to suppress improvement in the UE rate. Even given that assumption, we believe continued total monthly jobs growth in the 200,000 range would push unemployment down to 7.0% by year-end 2013 and to the Fed's targeted 6.5% rate by mid-year 2014.
Tapering: Timeline & Implications
In a recent presentation to investors, Argus President John Eade offered a potential timeline for the taper, along with what we see as the collateral effects of winding down QE. The Federal Reserve currently averages $85 billion in security purchases per month, with about $40 billion being mortgage-backed securities and $45 billion in U.S. Treasury notes and bonds. In addition to its unemployment rate target, the Fed is committed to encouraging activity in the U.S. housing market and will seek to suppress rates via its asset purchases in order to keep the housing market healthy. We expect the Fed to completely unwind purchases of U.S. Treasury instruments before it begins to reduce purchases of mortgage-backed securities.
Beginning late in 3Q13 or early in 4Q13, we expect the Fed to reduce its purchase of U.S. Treasury instruments to the $20-$25 billion per-month range. The Fed will likely retain its flexibility to add or subtract to the monthly total based on economic conditions and market response to the change. We expect the Fed to actively assess the impacts of its reduced asset purchases on the economy, the U.S. Treasury market and other fixed-income markets (and on investor sentiment overall).
The tapering of QE is one of the most anticipated and analyzed events in the financial markets in recent decades. As such, many of implications of the taper are already evident or beginning to be evident in the economy and the markets.
The dollar hit its lows against a trade-weighted basket of currencies in summer 2011, amid the rancor and dislocation of the debt-ceiling imbroglio. It has since risen off its lows, and has further strengthened since the Fed first acknowledged its potential tapering timeline. But the dollar remains about 15% below its peak value on a trade-weighted basis. We expect the dollar to strengthen a further 5%-7% against its trade-weighted basket; its ultimate value against that measure will be partly determined by the pace of tapering in other QE nations.
The strong dollar will have impacts on commodity pricing, and that in turn will impact the economies of developing economies with a resource basis. Already this year, the combination of strong dollar and emerging-economy malaise (most intense in China) is hitting resource-based emerging economies harder than it is hitting emerging economies overall.
Unlike some investors, we are not yet ready to call an end to the "commodity super-cycle" that so richly benefited the emerging world in the prior decade. But nor are we forecasting an imminent rebound in industrial commodity prices. We believe gold will be subject to further downward pressure as a result of the above factors as well as the legions of former gold bugs-turned-bears.
The 10-year Treasury yield, which appreciated by more than a percentage point between early May (1.63%) and early July (2.72%), is now in the 2.5% range; some investors assume it has stabilized there. The 10-year yield may well stick around 2.5% if the domestic economy slips into its partly seasonal mid-year pause.
Over time, we expect long yields to move higher, partly in response to the improving economy and the absence of a key buyer (the Fed). As the economy normalizes, we also look for interest rates to recapture some portion of their historical premium to inflation. That premium has ranged up to as much as 220 bps. Given a 12-month change in CPI (as of June 2013) of 1.8%, a more "natural" level for the 10-year yield might be in the 3.5% or even 4.0% range.
We may be in an era of structurally lower risk premiums, given freer global money flows, the multi-decade decline in global long-bond rates and tamer inflation. Given these circumstances, the historical risk premium may be overstated. For that reason, we spoke of bond yields recapturing "some portion" of their historical premium to inflation.
A host of data points -- beginning with jobs but including housing, automotive, non-defense capital and durable goods orders, and consumer spending and sentiment -- support sufficient recovery and expansion in the U.S. economy to compel the Fed to begin tapering. As it unfolds, tapering will strengthen the dollar, which will pressure commodities and gold, and gradually push market rates of interest higher.
The strong dollar/weak commodity environment, China's "re-set" as it seeks to stamp out shadow banking, and emerging economy malaise overall should cause further disinvestment in emerging economy markets. We are already seeing significant fund flows out of bonds. Much of this money appears to be going to cash, but it cannot stay on the sidelines forever -- particularly if invested fund managers are recording gains.
Given the attractive economic fundamentals in the United States along with prospects for continued growth in continuing operations earnings, we expect some of the uprooted money to find a home in the U.S. equity market.
(Jim Kelleher, CFA, Director of Research)
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.