When the sun rises on December 19th, I believe there’s an even chance that the Federal Reserve will have announced that they’ll begin tapering their bond-buying program that began in September 2012. I’d put 50/50 odds on an announcement of tapering their US$85 billion per month program of quantitative easing, and there are several fundamental reasons that back up my beliefs.
The potential federal budget deal that arose late in the day on Tuesday, December 10 between House and Senate negotiators is the most recent, albeit least important, piece of evidence paving the way for a December taper. When the Fed initially began signaling that they could begin reining in QE in September (which, coincidentally, I think they should have done), there was a looming government shutdown driven by a lack of a budget deal, and a bitter partisan row over the government’s statutory debt limit that presaged a possible sovereign default. These factors certainly weighed on the Fed’s decision not to taper. This week’s potential deal, while modest in absolute terms, does demonstrate that Democrats and Republicans can reach some form of agreement to avoid another shutdown. That removes a potential source of worry from the Fed’s field of view.
More importantly, I put a lot of emphasis on the U.S. private-sector recovery and I believe that it’s underpinned by fundamental factors that are much stronger than most people realize. The U.S. economy is benefitting from low energy costs. For example, the United States currently has extremely cheap natural gas – in some cases a quarter of the price seen in other countries. We’re seeing continuing improvement in the housing sector; it’s not rampant improvement, but decent. There’s also a sustained benefit from innovation, both in technology and productivity. Combine all these factors, and you can say that private sector growth is respectable.
And I understand that growth between 2.5% and 3% doesn’t feel like a particularly bang-up level – but it’s very steady growth. I’m encouraged by the fact that there’s a positive output gap in the United States; meaning, there’s still spare capacity in the economy. 2.5% to 3% growth isn’t particularly impressive, but it could potentially continue for the next two or three years…absent a big public policy error, which is what we’re all concerned about. Hopefully, this week’s budget deal goes some way to ensuring that a shutdown or default are much less likely in 2014.
As I mentioned earlier, I think that the Fed should have tapered back in September. It feels like we’ve now moved past the point where the asset-purchase program is delivering diminishing returns. I’d argue QE is now delivering negative returns. And I say that because the zero-interest-rate policy, at the margin, continues to take purchasing power away from retirees. Interest rates equate to income levels for retired individuals. If you’re retired and you’re rolling certificates of deposit to support your retirement, what do you do when the CD you rolled five years ago that pays somewhere north of 4% matures this week? You’re not likely to get another that’s paying 4.5% – in fact, you’d be lucky if you could get around 1%. The zero-interest-rate policy has also been a hindrance to pension plans, where low interest rates have made their solvency levels look much worse.
If the Fed does decide to taper QE at their meeting on December 17th and 18th – and I’d stipulate that most of the market hasn’t been expecting this – I think you’ll see a very temporary setback for equities. Bonds, on the other hand, could be hit with a setback that might be rather permanent. That would mean that 2014 could feel a lot like 2013 in the hierarchy of asset-class returns. U.S. equities should do pretty well because of the fundamental private-sector strength. U.S. bonds could have a very difficult year, and bond managers who’ve been in denial about the U.S. recovery may look back remorsefully on the December Fed meeting.
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