“From a fundamental perspective, the unemployment rate, which is what the Fed watches, has come down close to 7%. But does this rate really reflect the underlying fundamentals of the economy?” Seidner asked.
Seidner showed the audience a graph by Haver Analytics that plotted (through 8/31/13), the percent employed versus the unemployment rate (%) back to 2000. Although the unemployment rate is now closer to the Fed’s target, the ratio of the number of people employed to the total population (currently about 58.5%) has not budged since 2008.
On the surface, people tend to focus on signs of growth in the economy — housing, the manufacturing sector renaissance, and energy independence. And it is true that these longer term trends are improving. But in the here and now, the number of people working has not improved and seems stuck at 58% (vs. about 64.5% in 2000). Seidner believes the employment to population ratio is a much better gauge of economic strength (or lack thereof).
Next Seidner turned to valuation levels and asked what is the right equilibrium real rate of return on cash and short-term securities? Today’s two-year Treasury bond rate, five years forward is about 4%. The Fed is targeting 2% inflation, leaving a 2% real rate of return, which happens to be the historical (ex ante) rate that investors earned over the last 30–40 years (and yes, there could have been some excess premium that came out of the 1970s and 1980s).
But is it realistic to expect this in the future, especially for an economy that is 350% levered and (by definition) very sensitive to interest rate movements? “Two percent real return on short-term securities for taking no risk, would be a gift,” said Seidner, “and if offered, would cause the economy to slow quickly.” He believes the real return investors should expect from not taking any risk will be much lower than has been historically observed.
So if the economy is not as strong as some believe, and real rate projections on cash are too high, it’s not likely that the Fed will tighten any time soon. “We saw the turmoil created in the bond markets in the May-July period when the Fed hinted about tapering — mortgage rates rose and began to choke off the only bright spot in the economy,” Seidner noted. On the other hand, the Fed wants and needs to get out of the business of buying mortgages and Treasuries.
It’s not clear to Seidner whether the benefits of QE are outweighing the costs at this point. But tapering is very different from tightening. “A focus on the policy rate is still critically important to bond investors,” he said.
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