Chandler Bond Market Review

What Is The Fed’s Next Move?

Investors’ bias has shifted rather dramatically over the past month, as disappointing economic data has fueled speculation that the Fed may accelerate the pace of its asset purchases to provide additional stimulus to the economy.  This notion is driven by the fact that the Fed has clearly linked its guidance for policy action to economic markers and moved away from its previous calendar-based guidance.  The Fed has said since December that an exceptionally low fed funds rate will be appropriate as long as unemployment remains above 6.5% or until inflation looks set to exceed 2.5%.  With unemployment currently at 7.5%, and core CPI at 1.9%, the economy appears ripe for further stimulus.  However, just weeks ago, some market participants were beginning to think that the Fed would scale back its quantitative easing (QE) program before the end of this year.  The recent deceleration of economic growth has made the outlook for QE uncertain.

Fed policymakers seem conflicted by the data.  For example, in early April, Federal Reserve Bank of St. Louis President James Bullard said he favored reducing monthly asset purchases by $10 to $15 billion increments.  However, just a few weeks later, Mr. Bullard spoke at a conference in New York and warned that inflation remained too low and suggested that the Fed could increase its rate of asset purchases.  Richmond Fed President Jeffrey Lacker, who was strongly opposed to additional QE last September, said at the end of April that he would give serious thought to increasing stimulus if disinflation persists.  Nevertheless, we believe current monetary policy is largely being steered by Fed Chairman Bernanke, Vice Chairman Yellen, and New York Fed President Dudley, who have all been supportive of QE. 

As long as unemployment remains unfavorably high and consumer prices remain under control, the Fed is likely to remain focused on growth.  The statement from last week’s Federal Open Market Committee meeting indicates that the Fed may increase or reduce the pace of its asset purchases, depending on the outlook for the labor market and inflation.  For now, the Fed will continue to purchase mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month.  We believe this program is likely to remain on track through the end of this year, and that it is premature to speculate about a reduction in QE.

Why has investor rhetoric recently shifted toward increased QE?  We believe the data speaks for itself.  As reflected in the tables below, there was a rather dramatic reversal in economic data for March (which was released on a lagged basis throughout the month of April), after a string of positive data for February.  Though one month does not necessarily indicate a trend, we believe the impact of fiscal tightening at home and abroad is beginning to negatively impact economic growth.  Not only have we seen weaker economic data in the U.S., but fundamental concerns about the growth trajectory in Europe have increased with the ECB cutting policy rates last week and hinting at the possibility of providing additional credit measures to fuel growth.  This week, the European Union warned that a recession in the euro zone is likely to continue through the rest of this year.   In the U.S., we believe the impact of sequestration (which went into effect on March 1st) may have begun to ripple through the economy over the past two months.  We also suspect that rising healthcare costs and the recent increase in payroll taxes have put pressure on consumer spending.

May 2013 Article Table

In addition to the deceleration in economic growth during the first quarter, corporate earnings results for the period were also somewhat disappointing.  So far, more than 80% of companies in the S&P 500 Index have reported their first quarter 2013 earnings results.  According to data compiled by Bloomberg, of those companies that have reported, more than half have posted lower than expected sales for the period.  While first quarter earnings per share have been largely better than expected, we believe a lot of the upside has been driven by low-quality factors such as accounting adjustments and share repurchases.  In addition, year-over-year earnings growth was generally weak in the first quarter, up just 2.4% on average (compared to 9.2% in the fourth quarter).  Sales actually declined 1.4% year-over-year on average, according to Bloomberg data, compared to 3.6% growth in the fourth quarter.  Weak topline results are particularly worrisome, considering that revenues are much more difficult than earnings to manipulate with accounting treatments.  In addition, we believe management guidance has been more negative than prior quarters, and many companies continue to focus on cost-cutting rather than growth initiatives.  Overall, we would characterize first quarter corporate earnings season as being rather lackluster, adding fuel to the speculation that the Fed could step in to provide further stimulus.

The Fed’s most recent statement asserted that “fiscal policy is restraining economic growth.”  This language was more intense than the Fed’s previous comment in March that fiscal policy had become “somewhat more restrictive.”  If fiscal tightening is to blame for the deceleration in March economic data, we believe economic growth is poised to decelerate further, considering that cost-cutting from sequestration still unfolding.  However, there is also the possibility that the government will intervene and replace sequestration with a watered down package of spending cuts.  We believe last week’s better than expected jobs report for April (and the upward revision to payrolls for March and February) reduces the probability of the government making revisions to sequestration and reduces the probability of the Fed adding stimulus.  In fact, we believe the rhetoric could shift back toward tapering of asset purchases if the employment report for May is strong.

Our base case scenario assumes that domestic economic growth remains slow and the Fed remains highly accommodative for at least the next 6 months.  We also believe sequestration is likely to remain in place over the intermediate-term, and that restrictive fiscal policy will continue to be a drag on the economy.  However, we expect that an ongoing recovery in housing through the second half of this year will provide a modest tailwind to economic growth. 

 –          Shelly Henbest

                   VP, Credit Analyst

 

 

RISKS AND OTHER IMPORTANT CONSIDERATIONS

This report is provided for general information purposes only and should not be construed as specific legal, tax, or financial planning advice. All opinions and views constitute judgments or relevant information as of the date of writing and such information may become outdated or superseded at any time without notice. This report is not intended to constitute an offer, solicitation, recommendation or advice regarding any securities or investment strategy. This information should not be regarded by recipients as a substitute for the exercise of their own judgment. Fixed income investments are subject to interest, credit, and market risk. Interest rate risk: the value of fixed income investments will decline as interest rates rise. Credit risk: the possibility that the borrower may not be able to repay interest and principal. Low rated bonds generally have to pay higher interest rates to attract investors willing to take on greater risk. Market risk: the bond market in general could decline due to economic conditions,especially during periods of rising interest rates.

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