The Fed, in a bit of a surprise, announced they would begin
to “taper” their monthly purchases of US Treasuries and Mortgage-backed
securities. Many, including yours truly, believed the Fed would wait until
March, after the new Fed Chairwoman had been installed. Never discount the
ability of the Fed to chart its own path.
The market responded to the news of the modest “tapering”
much as a six year-old greets Christmas morning, with much happiness and joy.
Stocks reached new all-time or multi-year highs while the response of the bond
market was relatively muted.
The Dow hit a new all-time high of 16,287.84 (it’s now up
+22.06% over the past year); the S&P 500 soared to 1,823.75 (up +26.07%
over the past twelve months); and the NASDAQ reached 4,111.93 (up +34.65% over
the past 365 days and its highest level since 2000).
The big news in the US Treasury market was the flattening of
the yield curve. The yields on the short-end and the belly-of-the-curve are
rising while the longer-end of the curve is dropping. Over the past two weeks,
the 2-year yield is up +7bps to 37bps; the 5-year note yield is up +17bps to
1.67%; the 10-year note yield is unchanged at 2.88%; and the 30-year bond yield
is actually down -9bps to 3.82%.
There are a couple of factors in play that are causing the
flattening to occur. First, the market now believes the Fed is actually going
to start raising interest rates a little bit sooner than it had. Given the
2-year UST yield is trading at 37bps, the market is inferring that the Fed
might start increasing the Fed Funds rate in the late 2014/ early 2015 time
period. Second, the belly-of-the-curve has backed-up mainly on concerns of
supply. There is a large amount of 3-to-7 year debt to be issued in the near
future, and given the increased optimism for the US economy, higher yields may
be required for investors to participate. Third, the back-end of the UST yield
is actually rallying because there is currently no threat of inflation on the
horizon and because the Fed seems to be taking a gradual approach to its
“tapering”.
On that final note, many market participants believe the Fed
will reduce its purchases of Treasuries and MBS in a very gradual and orderly fashion.
If the Fed were to reduce its purchases by -$10 billion per each FOMC meeting
in 2014, they would complete the process by the end of 2014, and position them
to start raising the Fed Fund rate as soon as late 2014/ early 2015.
Not to be lost in all the Fed news, but here in the United
States we passed our first budget out of a divided government in 27 years
(we’re talking 1986, think “West End Girls” by Pet Shop Boys). So other than
battling over the debt ceiling, the budget shouldn’t be a government-closing
issue for the next year or so.
Happy Holidays!
