In homes around the world, anxiety and uncertainty are at a fever pitch - what will Santa bring? Financial markets got their answer last week when an extremely dovish Federal Reserve Board Chairman Ben Bernanke used his final post-Federal Open Market Committee meeting press conference to eliminate any uncertainty over who really is Santa Claus. U.S. equity markets immediately rallied, responding to the signal that any eventual interest rate increase is farther off in the future than investors had previously anticipated. U.S. Treasury 10-year yields barely moved, having already priced-in the $10 billion reduction in the Fed's program of quantitative easing.
It is hard to overstate just how dovish the Fed's statement actually was. While the taper of asset purchases is small and well-signaled, the Fed also told us that while the unemployment threshold may still be 6.5 percent, it is prepared to keep the federal funds target rate at the zero-bound "well past" that level. Finally, the Fed for the first time included an explicit lower boundary for inflation of 2 percent, below which it will not raise rates. I have long felt that the Fed would wait until 2016 or even 2017 before raising the fed funds target rate, and the FOMC comments on inflation and unemployment give the central bank the room to do just that.
We have been closely analyzing interest rate movements since the backup following the Fed's June FOMC meeting. We expected 10-year yields to hit a peak at 3 percent, something I wrote about in my September 17th commentary, "Rising Interest Rates Must End Soon." Yields have not moved above that threshold since then, even after Dr. Bernanke's announcement last week that the Fed would reduce purchases starting in January. For 2014, I expect the 10-year yield will remain range-bound and less volatile. Some market observers expect yields will rise because tapering is about to start, however, now that we have passed the moment of maximum uncertainty, we could actually see yields fall. Less uncertainty, lower volatility and the green shoots of a global synchronous expansion are all positive for risk assets. Not only did Ben Bernanke give equity markets an early Christmas present, he gave bond market investors a chance to rest and to dream of more sugar-plums and candy canes coming next year.
Reduced Policy Uncertainty is Positive for U.S. Equities
The decision by the Federal Reserve to begin tapering quantitative easing next month removes a substantial amount of uncertainty from the market heading into 2014. Fiscal and legislative policy uncertainty are also on a downward trend, with October's congressional battles behind us and the recent budget deal creating more confidence in the ability to reach a political compromise in the near term. Given that increases in uncertainty have weighed on stock market gains over the past several years, these developments could be positive for U.S. equities over the next few months.
ECONOMIC POLICY UNCERTAINTY INDEX AND SIX-MONTH CHANGE IN THE S&P 500
Source: Baker, Bloom, and Davis (2012), Bloomberg, & Guggenheim Investments. Data as of 12/22/2013.
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