Federal Open Market Committee’s impact on investments this week

Part 2
Federal Open Market Committee’s impact on investments this week (Part 2 of 7)

Investors prepare for the Federal Open Market Committee meeting

Preview: Fed’s FOMC meeting, June 17-18

This week, the third of the Fed’s eight annual Federal Open Market Committee (or FOMC) meeting will be held on June 17–18. This is usually a market-moving event, impacting both stock (SPY) and bond (BND) markets. A dovish statement would imply the economy isn’t recovering as expected and the Fed would keep rates low for a longer period than anticipated, benefiting fixed income investors. On the other hand, stocks would be boosted if the Fed’s forecasts for gross domestic product (or GDP) growth and the labor market, which were released at the end of the March FOMC, are revised upwards.

Investor expectations

This time, the Fed is widely expected to continue with its current rate of tapering asset purchases, reducing its purchase of longer-term Treasury securities (TLT) and agency-backed securities (MBB) by $5 billion each. This would reduce the Fed’s monthly bond buying program to $35 billion. The Fed would be on track to complete tapering by its October FOMC meeting. There may be additional surprises for fixed income markets (AGG) in terms of the new tools the Fed is testing, and exit strategies the Fed is looking at in order to normalize its monetary policy.

Part 2Enlarge Graph

New appointees at the Fed

At this week’s FOMC meeting, there will be three new members on the 12-member committee: Former Bank of Israel Governor, Dr. Stanley Fischer, who has recently been confirmed as the vice-chair by the Senate; new head of the Cleveland Fed, Dr. Loretta Mester; and former Treasury Under-Secretary for International Affairs, Lael Brainard, who has been confirmed by the Senate and as a Governor on the Board.

Key takeaways from the April FOMC

At the last FOMC, the Fed continued with its tapering of monthly asset purchases, reducing the purchase of longer-term Treasuries (TLT) and agency-backed securities (MBB) by $5 billion each, bringing the total monthly bond purchases to $45 billion.

On the Fed funds rate

The FOMC statement after the meeting, also mentioned that the Fed would keep the Fed funds rate low “for a considerable period” after asset purchases end. According to the April FOMC minutes, “the Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”

On normalization and exit strategies

At its April FOMC, the Fed also discussed strategies for normalization of the Fed’s monetary policy stance, including the Fed’s balance sheet and the base rate. The Fed discussed several approaches on the mechanics of increasing short-term rates and controlling movements in the same, at a time when the Fed’s balance sheet is ~$4.3 trillion—an unprecedented high. The tools discussed were:

  • Interest on excess reserves
  • Fixed-rate overnight reverse repurchase (ON RRP) operations
  • Term reverse repurchase agreements
  • The Term Deposit Facility (TDF)

The Fed’s economic forecasts

At the end of the March FOMC, the Fed released its forecasts for economic variables like the GDP, inflation, unemployment, and the Fed funds rate.

  • Long-term unemployment rate range was estimated at 5.2%–5.6%, unemployment rate at the end of 2014E—6%–6.5%
  • Long-term inflation rate 2%; inflation rate at the end of 2014E—1.3%–1.8%
  • Fed funds rate: refer to schedule above in the first graph.
  • Long-term real GDP growth estimate—2.2%–2.3% p.a., real GDP growth for 2014E—2.80%–3%.

Outlook

At the June FOMC meeting, three new members will be voting, and their estimates are likely to impact the above forecasts. However, due to the negative GDP surprise in 1Q14, when GDP contracted by 1% due to poor winter weather, the Fed is likely to revise its 2014 GDP growth estimate downwards. The timing of increase in the Fed funds rate shouldn’t differ significantly given the Fed’s dovish stance.

Inflation and unemployment forecasts shouldn’t differ materially as well. Although the level of nonfarm payrolls are almost at pre-recession levels and the unemployment rate is down since the start of the year, economists must assess whether an improving economy would increase the workforce participation rate and the need for more job creation. Although the inflation rate increased to 1.6% in April, one reading may be insufficient to gauge whether this is an upward trend.

Ticker index

TLT is the iShares 20+ Year Treasury Bond ETF. SPY is the State Street SPDR S&P 500 ETF. MBB is the iShares Barclays MBS Fixed-Rate Bond Fund. BND is the Vanguard Total Bond Market ETF. AGG is the Core Total U.S. Bond Market ETF (AGG).

In the next section, we’ll discuss the major housing indicators that will release this week and their impact on stock and fixed income ETFs.

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