'Tapering' Is tightening

By the Fed’s own admission, the asset purchases were designed to “maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative,” so the cessation of quantitative easing represents at least a partial tightening of monetary policy. The mere mention of “tapering” by Bernanke has already pushed the 10-year Treasury yield up by a greater amount than during the entire previous FOMC tightening cycle (June 2004-June 2006).

We believe that the Fed's substantial monthly asset purchases, even now, continue to promote market interest rates at abnormally low levels. For example, the yield on the five-year Treasury note, while elevated in recent weeks at 1.47 percent (Aug. 14, 2013), remains far below core Consumer Price Index (CPI) inflation of 1.7 percent (July 2013). From this perspective, interest rates potentially have additional room to rise should U.S. economic fundamentals reinforce the Fed’s intention to begin paring back asset purchases before year's end. Add in the prospect of even a slight uptick in measured inflation as U.S. labor market conditions tighten and unemployment declines, and we could easily be looking at an additional 25 basis points (bps)-50 bps rise in intermediate Treasury yields in the months to come.

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However, we also recognize that the modest tightening of monetary policy associated with recent Fed tapering rhetoric has had a detrimental effect on the U.S. housing market recovery, which we believe was the focus of the stimulus in the first place. The 30-year fixed mortgage interest rate has risen by 50 bps since mid-June and by 100 bps since the start of the year, which has tempered the enthusiasm of prospective homebuyers. The Mortgage Bankers Association’s (MBA) application-to-purchase index has declined precipitously in recent weeks, reaching levels that are broadly consistent with those recorded in September 2012 when the Fed first announced QE3 to shore up the U.S. economy and housing market. Judging by the MBA’s purchase application index, over the past couple of months the housing market has surrendered all of the momentum it built, with the support of QE3, between October 2012 and May 2013.

This decline potentially places the U.S. economy, the Fed, and, by default, the outlook for financial markets in a fairly precarious position. The Fed clearly wants to see the economy improve to the point where they can begin winding down their asset purchase program, but has Bernanke's mere mention of tapering somehow short-circuited this intention? We see two possibilities.

The first, and more likely, outcome is that the improving global economic outlook, particularly in the U.S. and Europe, will maintain downward pressure on historically elevated global unemployment. Consumer confidence continues to improve, and prospective homebuyers return to the housing market after having weathered the initial episode of rising mortgage interest rates since the start of this year.

The second scenario is that the U.S. housing recovery transitions to a period of much more modest activity in the second half of this year, following its strong first half, requiring the extension of Fed stimulus well into 2014. This second scenario would be unwelcome news for investors as revenue growth has turned negative among S&P 500 corporations for the first time since third quarter 2009, when the economy was exiting the recession. Revenue growth is expected to rebound 4-5 percent in the second half of 2013, but this could prove difficult without a healthy pickup in domestic demand as a byproduct of a sustained housing recovery.

The presentation of our two hypothetical scenarios regarding the recent relationship between the housing market and QE3 tapering potentially touches upon a bigger question: What is the prospect of the Fed actually completing its exit from the QE3 asset purchase program (involving monthly purchases of $40 billion of Agency MBS and $45 billion of longer-term Treasury securities)?

The Fed's current quantitative easing policy cannot be continued in perpetuity; however, what does it say about the fundamental state of the U.S. economy that just the mention of the word “tapering” could result in the postponement of said tapering? GMI Research believes that as long as the U.S. labor market continues to improve, generating increased consumer purchasing power while maintaining downward pressure on unemployment, there is little reason to doubt that some degree of tapering will commence sometime in the next six months. As long as the next leg of the recovery produces improved, but still moderate, GDP growth in a benign inflationary environment, we believe that the economy and financial markets should flourish despite any equally modest monetary policy tightening associated with either conventional or unconventional policies since they will likely remain accommodative for years to come.

Keiser is vice president of S&P Capital IQ Global Markets Intelligence, an institutional investment advisory business with over $20 billion in assets under advisory.

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