What Taper? Low Rates for Longer Is Key Fed Theme for 2014
NEW YORK -- Debate over when the Federal Reserve could trim its bond purchases monopolized market talk this year, but as a new Fed chief takes charge, more participants believe the key theme to emphasize for 2014 is low rates for longer.
For the bond market, which suffered a number of doomsday predictions for 2013 that never materialized, that means yields could also remain low. Even if they do rise, it might not be by much, since benchmark 10-year yields have already had a 100-plus basis point increase from lows hit in May.
"The Fed under [Fed Chair nominee] Janet Yellen will be committed to a very low federal funds rate for several more years," said Jake Lowery, Treasury trader and portfolio manager for global interest rates at ING U.S. Investment Management.
"That commitment to low rates is much more important than the precise timing of tapering," Lowery said, referring to potential reductions in the Fed's large-scale purchases of U.S. Treasuries and mortgage-backed securities.
Fed Chair nominee Janet Yellen, testifying before the Senate Banking Committee this month, strongly defended the Fed's bold steps to spur economic growth, calling efforts to boost hiring an imperative. Outgoing Chairman Ben Bernanke also argued that case last week, saying the way to normalized policy in the future was through heavy stimulus now.
"The FOMC, and especially a Yellen-led FOMC, will put a lot of weight on the employment side of its mandate and it's going to take a long time to get unemployment down to where the Fed wants it to be," said Goldman Sachs (GS) chief economist Jan Hatzius in a recent webcast. %VIRTUAL-article-sponsoredlinks%Hatzius said he expects the Fed to cut its threshold for unemployment to 6 percent from 6.5 percent. The U.S. unemployment rate currently stands at 7.3 percent.
That means 2014 could be another good year for riskier assets, and a bumpier one for safer fixed income investments.
"Returns of seven or eight percent on a fixed-income portfolio when the Fed pursues a zero percent interest-rate policy are just not possible," said Eric Stein, co-director of the global income group at Eaton Vance Investment Managers.
In 2013, only junk bonds produced good returns. Investment grade corporates lost money as have most classes of Treasuries.
The increased conviction that interest rates will remain lower for longer means investors will favor yield without duration. It also means bad economic news is good for stocks as it implies a longer period of Fed accommodation.
"The economy is too weak for the Fed to consider a pullback in quantitative easing, let alone an abandonment of zero percent interest rates," said Jeffrey Rosenberg, BlackRock chief investment strategist for fixed income.
Two misperceptions have kept some investment managers and traders from recognizing that rates will remain lower for longer than they think, said Robert Tipp, chief investment strategist at Prudential Fixed Income in Newark, N.J., with $400 billion in fixed-income assets under management.
"First, investors underestimate the need for accommodation in the global monetary system," he said.
The euro zone recovery is slow, driving a similar low-rates-for-longer policy at the European Central Bank, he said.
Bank of Japan Governor Haruhiko Kuroda said on Monday the bank would further expand stimulus if growth wassn't strong enough to boost inflation to 2 percent.
"Second, the U.S. economy also remains slack," Tipp said.
After enduring a sell-off mid-year when the Fed intimated a small pullback in stimulus was on the way, bond rates dropped when the Fed decided to carry on purchasing bonds at its current rate. Yields since then have risen. The 10-year note now yields 2.75 percent.
Higher long-term rates can potentially choke off a recovery, a hint of which can already be seen in the housing sector where sales of existing homes fell last month.
"The Fed probably is not in love with this steep of a yield curve because of the impact on mortgage rates," said Jeffrey Kronthal, co-founder of KLS Diversified Asset Management.
Fed Research Examines Forward Guidance
Top Fed economists have also suggested the Fed might rely more on giving forward guidance on the path of interest rates by, for instance, adjusting its thresholds on inflation and unemployment to signal rates will stay low even as the recovery picks up. That guidance could compensate for some reduction in the Fed purchase program known as quantitative easing.
This would give the Fed "a way of committing to keep interest rates lower for longer than would otherwise be the case under conventional policy, and thereby improve economic outcomes," Fed economists William English, J. David Lopez-Salido, and Robert Tetlow said in a paper presented earlier this month at a research conference hosted by the International Monetary Fund in Washington D.C.
Some Are Skeptical
Some policymakers and strategists worry monetary stimulus is already fueling inflated asset prices and higher leverage that could hurt the economy when reversed.
The Bundesbank recently warned that the eurozone's record low interest rates posed risks to the financial sector if they remained in place for a long time.
Some strategists think improved sentiment in purchasing managers surveys foreshadows recovery in the United States and elsewhere and that rates will rise in 2014.
But even if they did, the risk of another 100-basis-point rise in 10-year yields is lower since those yields have already risen more than a percentage point from their 2013 low, said Zach Pandl, strategist at Boston-based Columbia Management, with $345 billion in assets under management.
"We've already had a large valuation correction," he said.
Overall, said Payden & Rygel economist Jeffrey Cleveland, "there's a non-trivial chance of 2014 being just like 2013 which is 2 percent-type economic growth. That means short-term interest rates will remain low for longer."