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Tapering and Treasury yields: Important takeaways

Tapering and Treasury yields: Important takeaways (Part 1 of 4)

Must-know key updates: The FOMC concludes its two-day meeting

The FOMC meeting

The Federal Open Market Committee’s (or FOMC) two-day meeting concluded on March 19, 2014. It was one of the most pivotal events of the week. There were two major outcomes of the meeting. One, which was quite expected, was tapering to remain as scheduled. However, the threshold of 6.5% unemployment rate to trigger the increase in the Fed funds rate has been replaced with more generic approach using a range of economic data with no specific target. The labor market indicators exhibited mixed performance but on an average showed further improvement. The unemployment rate, however, remained elevated. Further, the forecasts on gross domestic product growth (Or GDP) and civilian unemployment rate have been revised downward. Inflation numbers are essentially unchanged from December.

Non-Farm PayrollEnlarge Graph

Tapering continues

The Fed funds rate would remain unchanged and taper remains as scheduled, said Janet Yellen, chairwoman of the Federal Open Market Committee (or FOMC).

As scheduled, the Fed is expected to cut another $10 billion of asset purchases in April, 2014. This means that the Fed would buy $25 billion of agency mortgage-backed securities (MBS) in April 2014, down $5 billion from March 2014’s MBS purchases . The Fed would buy $30 billion worth long-term Treasury securities in April 2014, down by $5 billion from March 2014’s number.

Dovish statement on economic growth

The FOMC indicated that the growth in economic activity slowed during the winter months, in part because of adverse weather conditions. The statement was quite opposite to what the FOMC felt about the economy when they met in December when the statement made by the Fed was, “economic activity picked up in the recent quarters.”

Focus is on maximum employment and price stability

The unemployment benchmark of 6.5% set earlier has become stale, as the Fed believes that the unemployment rate is not the perfect measure of the labor market conditions, and it would be appropriate to assess a broader range of information to make a decision on further tapering and subsequent interest rate hike. Janet Yellen mentioned that the, “labor market has improved more than expected, however, loose policy will continue until the outlook for the labor market would improve substantially in a context of price stability.”

For assessing the labor market, along with the unemployment rate, the Fed would closely watch the Job Openings & Labor Turnover Survey (or JOLTS) report and the wage inflation, which is signaling labor market weakness. The JOLTS data reported for the month ended January showed 4.0 million job openings, little changed from 3.9 million job openings in December 2013. The hires rate was 3.3% and the separations rate— people quitting the job was 3.2%.

The JOLTS data is a powerful indicator of the employment situation in the country. Increase in the JOLTS index indicates that high number of jobs is available in the market. Other things being constant, job creation uplifts the consumer purchasing power, which in turn increases the demand for both durable and non-durable consumer products. When purchasing power increases, people tend to pay more for the same good than they did before, driving the inflation upward. This prompts central banks to raise interest rates to control the inflation. As bonds prices are inversely related to interest rates, the bond prices fall when interest rates rise.

Some of the major fixed income ETFs includes Vanguard Total Bond Market ETF (BND) and iShares Barclays 20+ Year Treasury Bond Fund (TLT). To hedge against the rise in the interest rates, investors may consider ETFs such as PowerShares Senior Loan Portfolio (BKLN) with top holdings in H.J. Heinz Company (HNZ) (1.8%) and Dell International (DELL) (1.3%). The ETF adjusts with the change in the market interest rates.

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