In the wake of the latest Washington fiasco, it is important to assess impacts on Federal Reserve policies and interest rates, as these have become critically important for many investments. Our "leaders" have narrowly avoided a self-inflicted catastrophe by "kicking the can down the road" a few months and virtually guaranteeing a sequel to this month's dismal spectacle. Political realities make it clear that the most likely scenario is a series of these lurching compromises punctuated by periodic moments of sheer terror at the prospect of an actual default. Like a pyromaniac who promises to stop playing with matches but only for the next 90 days, Congress will return to crisis mode and may even become addicted to it.
In this climate, the Federal Reserve will find it difficult to take any action which could stall the economy. In this regard, a scale back of Quantitative Easing would probably not create a massive direct effect on economic activity. However, market psychology is such that it could set off nasty movements in interest rates, exchange rates and investor confidence. This past Summer, the mere mention that "tapering" might begin resulted in higher long term rates, lower valuations of interest rate sensitive stocks and an especially nasty downturn for agency mortgage REITs. Higher mortgage rates and a stronger dollar could have severely adverse effects on an economy which is just barely growing. With the specter of government shutdowns and possible defaults on the horizon, the Federal Reserve is very unlikely to "taper" before its April/May, 2014 meeting. In fact, one may see the word "taper" slip away from the Fed's vocabulary and be replaced by a more ambiguous euphemism.
So, it becomes interesting to map out likely Fed actions over the 26 remaining Open Market Committee meetings (2 more this year and 8 each in 2014, 2015, and 2016) between now and 2017. As noted above, the Fed is very unlikely to taper and even more unlikely to raise rates at the remaining two meetings in 2013 and the first two meetings in 2014. When tapering was discussed, a crude consensus emerged that the tapering would probably result in a $10 billion per month reduction in bond purchases. Using this number and the $85 billion level of monthly purchases under QE3, it would take 8 or 9 meetings for tapering to bring QE 3 to an end. I think that the assumption that the Fed would promptly commence tapering at the third 2014 meeting and would move forward for 8 meetings without a pause involves very optimistic projections of economic and financial stability and is highly unlikely. A more realistic assumption is that things will not get started until the June 2014 meeting, proceed with fits and starts (with pauses for periodic debt ceiling scares, elections, and European debt scares) so that tapering will take at least 12 meetings - concluding - at the very earliest - at the October 2015 meeting.
Once QE3 is concluded, the Fed may spend several meetings reducing its balance sheet by engaging in net selling and will make adjustments to its "extended period" language to give warning that rising Fed Fund rates are about to occur. This puts the likely date for the first actual rate increase in early 2016. It takes 8 quarter percent increases to go from zero to 2 percent and the Fed will probably avoid raising rates in the September and October 2016 meetings because of the upcoming election. As a result, it will be very hard to get to a 2 percent Fed Funds handle before 2017.
A few important points. I am not predicting that we will actually get to a 2 handle in 2017 - instead, I am predicting that the Fed Funds rate will not be above 1 3/4 percent by December 2016. Things may proceed much more slowly and it is entirely possible that we will still be below 1percent. In addition, there are all sorts of things which could upset my timetable - inflation could increase substantially, the economy could experience a solid recovery, political harmony could emerge in Washington and debt ceiling crises, government shutdowns, and sequestrations could become distant memories. Pigs could also learn to fly, Hell could freeze over, and the Chicago Cubs could win the World Series. But don't hold your breath waiting for any of these things to happen!
In this article from May 2011, I predicted that there would be no Fed Funds rate increase until early 2013; I am not asking for applause but this article employs essentially the same approach. I was helped out by the August 2011 debt ceiling debacle but I am reasonably confident that Congress will come through for me again and do something really stupid that makes the Fed nervous and delays tapering and/or rate increases.
I believe that the sell off in interest rate sensitive equities has been overdone and would recommend that investors look at agency mortgage REITs - e.g., Annaly (NYSE:NLY), Business Development Companies - e.g. Ares Captial (NASDAQ:ARCC), and utilities. I have stuck my neck out here by being rather precise about my prediction and I anticipate some interesting comments. Just don't forget to come back and visit on December 31, 2016.
Disclosure: I am long NLY, ARCC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.