On Wednesday, Sept. 18, 2013, the Fed’s announcement that it would continue buying $85 billion long-term US Treasuries and mortgage-backed bonds every month until the broader economy shows stronger and stable economic growth helped the relief rally continue in the market. The S&P 500 and the Dow Jones industrials Average rose to all-time highs of 1725.5 and 15676.94, while Treasury prices rose, with the benchmark 10-year yield settling at 2.706%, its lowest since Aug. 12. Gold and Oil futures pushed higher. The dollar slumped against most major currencies.
The Federal Reserve statement came as pleasant surprise to investors since the market has been expecting around a $10-$15billion reduction in the Fed bond-buying program. The Fed indicated that a reduction in the market friendly program would happen once the employment situation improves and the unemployment rate falls to around 6.5%. Fed Chairman, Ben Bernanke, emphasized that employment numbers don’t necessarily portray the true picture of the economy and that he wanted to see the overall economy improving before the Fed starts reduces its tapering program.
Declining labor force participation, which is partly behind the easing unemployment rate, is making the Fed uncomfortable. The U.S. jobless rate in August was 7.3%. Despite this rate being the lowest since December 2008, the details were not pretty, as those individuals dropping out of the labor force (not actively looking for jobs) are not included in the rate. The labor force participation rate is at a 35-year low of 63.2% – and fell by 300,000 in August.
The move comes against the backdrop of a gloomier outlook for economic growth from=.The Fed, which lowered its growth estimate (3rd time this year) for 2013 from the 2.3% to 2.6% range to 2.1% to 2.3% range and for 2014, from 3% to 3.5% to 2.9% to 3.1%.
It kept the Fed funds target rate unchanged at 0.0% to 0.25%. The Fed reiterated that it would not begin to raise rates until unemployment falls to 6.5% as long as the inflation does not threaten to go above 2.5%. CPI is currently at 1.5%.
We had hoped that the Fed would consider inflation when deciding to reduce bond buying – since we did not see any inflationary pressure in the US economy. We had enumerated the reasons – low capacity utilization, overproduction in China and depressed employment markets. The Fed expects inflation to remain low and predicts an inflation rate of no higher than 1.2% in 2013, rising to a range of 1.7% to 2% by 2016.
While the broader markets reacted positively to the news, Homebuilder stocks surged sharply and the S&P Homebuilders index moved up by 3.26% and some stocks like KBH Home (NYSE:KBH), D R Horton (NYSE:DHI) surged 8.22% and 7% respectively.
While we had expected that a drop in bond buying will directly cause Mortgage Backed Security spreads to rise, the news will help prop up the mortgage markets in the near future. Mortgage rates had been rising in anticipation of the tapering – and can start easing again now and help these stocks.
WSA is cautiously optimistic. We have mentioned multiple times in all our publications that at these inflation and unemployment rates, the Fed should not taper – and we are glad to see that our assessment of the situation was correct. It was a smart move for the Fed to provide clear guidance on the levels of inflation and unemployment at which it will start tapering – so that these get priced into the market with every coming week. But valuations and the debt ceiling that the market seems to be ignoring in this Fed supported party.