FED Tapering & Its Impact on the Market

The Federal Reserve made public the minutes of its June meeting earlier in the week. The minutes of the Fed meet were much awaited. While it was already clear that the Fed would hike the rates once more in 2017 and thrice more in 2018, the markets were actually looking for greater clarity on the trajectory of the long term Fed rates as well as the tapering of the bond portfolio. The US Fed currently holds bonds to the extent of $4.5 trillion, which were accumulated as a result of consistent infusion of liquidity into the financial system. While the bond buying actually stopped in 2014 the reinvestment of redemptions has been continuing till date meaning that the outstanding value of bonds has remained around the $4.5 trillion. There have been calls from economists and experts to start unwinding the bond portfolio as it was skewing the interest rate structure in the US and consequently across the world.

Here are 6 key takeaways from the minutes of the Fed meeting…

• While the Fed did not announce any date on which the tapering the bond portfolio will commence, the indications are that it should start in the next couple of months (possibly September this year). The Fed has, however, clarified that the taper will be gradual and calibrated and hence it is unlikely to pose any risks to the financial markets. The markets were worried about the taper because it will have the reverse effect of sucking out liquidity from the financial markets. For asset classes driven by liquidity over the last decade, a more calibrated approach to taper is necessary to avoid disruptions and shocks.

• The Fed minutes have expressed concern over unemployment undershooting the target of 5% consistently. The US economy has defined 5% jobless level as “Full Employment” and with that indicator getting closer to 4%, the Fed minutes have clarified that there could be a strong case for a quicker rise in the interest rates. However, the wage growth continues to be tepid and that is perhaps the only saving grace.

• The Fed minutes dwelt at length on the inflation factor. While the Fed has targeted 2% inflation target as an equilibrium rate for sustained rise in the interest rates, the actual rate of inflation has been well below that level. While weak commodity prices have been one factor, the Fed has pointed out that in recent months, lower price of wireless services and also the prices of drugs and medicines have triggered lower inflation. The FOMC has admitted in this meeting that the US economy may have to adapt to a lower level of equilibrium inflation as 2% inflation is going to be hard to achieve. That, of course, could change drastically if the proposed tax cuts and the massive infrastructure spending actually materialize.

• Interestingly, the Fed has also dwelt at length on the emerging paradigm in the equity markets. The Fed has warned the financial markets not to get carried away by the apparent low volatility in the equity markets as it could be the harbinger of sudden shocks and disruptions in the equity markets. Fed has dwelt at length on the increasing risk-tolerance of investors towards equities. With equities consistently outperforming over the last 9 years due to a surfeit of liquidity, it has created a sense of misplaced optimism among equity investors. The Fed has highlighted this as a major risk for financial markets.

• The Fed has also highlighted a major mismatch in the overall economic valuation matrix in the US economy. For example, the equity valuations are at elevated levels compared to historic benchmarks while bond yields are just too low despite a hawkish Fed. While this may be due to longer term growth concerns, the Fed feels that it is creating an anomalous situation in the financial markets which could only be rectified by a mix of higher rates and a sharper tapering of the bond portfolio.

• Finally, the Fed has highlighted a fairly balanced economic outlook for the US economy. According to the Fed, the risk for US growth comes from other economies like the EU region which has seen a sudden return to growth. At the same time, there is also hope for the Fed that US growth could return once the fiscal measures in the form of lower corporate tax rates and higher infrastructure spending are implemented. It may be remembered that these were promises made by Donald Trump as part of his election campaign.

The broad thrust of the Fed minutes appears to be towards a quicker rise in rates and an early commencement of the tapering of the bond portfolio. While the Fed may still stick to its long term interest rate targets, it may look to front-ending its rates trajectory. Also the Fed’s approach to the tapering may be contingent on how other central banks react. For example, the ECB and the BOJ are also sitting on a combined bond portfolio of $7 trillion and if they also start tapering then the impact on global liquidity could be quite sharp.