Janet Yellen’s stance
Despite, a relatively weak jobs report last week, markets are expecting new Fed Chairman Janet Yellen to continue the steady tapering started in December. Non-farm payrolls in January increased by only 113,000, compared to a consensus estimate of 181,000. The unemployment rate has reduced marginally, from 6.7% in December to 6.6% in January. The Fed had floated guidance that 6.5% was the magic threshold number to start pulling back quantitative easing.
The Fed is expected to continue to reduce its monthly purchases of Open Market Securities currently composed of $30 billion in agency-backed mortgage backed securities and $35 billion in longer-term treasuries. The Fed had announced a $10 billion reduction in monthly purchases in both December and January.
Taking into account other positive signals from last week, like the hike in annual private construction spending in 2013 (up 8.5% year-on-year) boosted by residential construction (up 18% year-on-year), the steady marginal improvement in employment implies that the economy continues to expand and that unemployment will easily drop below 6.5%. This means the Fed will probably continue with its tapering by gradually ceasing its purchase of agency mortgage-backed securities and longer-term Treasuries. This will mean lower liquidity in the economy and rising interest rates, which will reduce the prices of fixed income securities.
The Treasury is also expected to announce its budget on Wednesday. The size of the Treasury’s budget surplus or deficit will impact the future supply of government debt issues.
A higher budget deficit will mean the Treasury will issue higher amounts of government debt to finance its deficit. This will increase the supply of government securities. If demand stays constant, the increase in supply of debt will mean lower prices and higher yields for government debt. As government debt serves as a reference for private debt, this will raise interest rates across the spectrum for private-issuer and semi-government debt securities as well. The reverse is also true. Other things constant, a lower deficit will mean lower issuance of government debt by the Treasury, higher prices, and lower interest rates for fixed income securities.
Plus, the market isn’t expecting pressure from the short end of the yield curve. The Fed, at its last meeting, had already stated that it would maintain the Fed funds rate between 0.0% and 0.25% well after the economy’s unemployment rate reached below 6.5% and inflation maintained the target 2% long-term level. To see how private businesses anticipate inflation next year, read on to Part 3 of this series.
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