We Don't See a Change in Bernanke's Policy Stance

BOND STRATEGIST: In addition to the strength or weakness of economic and unemployment metrics in the second half of this year, technical factors in the bond market may force the Fed's hand to begin tapering

Dave Sekera, CFA 17 July, 2013 | 5:31PM

The average spread in the Morningstar Corporate Bond Index rallied more than 12 basis points last Thursday to +143. This rally was in response to Federal Reserve chairman Ben Bernanke's assertion that he expected the Fed would continue its highly accommodative policy for the foreseeable future. 

While the media hype sent the markets higher, we don't think there is any substantive change in his policy stance since the Q&A session following the Federal Open Market Committee meeting June 19. We think Bernanke has been crystal clear that the Fed would begin to taper asset purchases as early as this autumn and end all purchases by next summer if the economy and the unemployment rate develop as the Federal Open Market Committee expects. According to the meeting minutes, it appears that the opinion to begin tapering the asset-purchase programme sooner rather than later is gaining traction as "several members judged that a reduction in asset purchases would likely soon be warranted." In addition to the strength or weakness of economic and unemployment metrics in the second half of this year, technical factors in the bond market may force the Fed's hand to begin tapering. The government's monthly deficit has been declining as a result of increased tax revenue, reduced spending increases from sequestration, and dividend payments from Fannie Mae and Freddie Mac. As such, the Treasury will not need to issue as much debt in the second half of this year and there will be less debt issued for the Fed to monetise. Considering that the Fed already owns a substantial amount of long-dated Treasuries, it will become increasingly difficult for the Fed to source bonds, causing even greater problems in the Treasury repo market.

The Fed has left itself a way to get out of tapering in the second half of this year--if the economy does not progress as it forecasts. In conjunction with the FOMC's statement June 19, the Fed released its updated economic projections. The increased forecasts surprised Bob Johnson, Morningstar's director of economic analysis, who wrote, "I suppose the only real surprise is that the Fed outlook for the economy is remarkably more bullish--too much so, in my mind. Its forecast for 2013 [US] GDP growth is 2.3%-2.5% compared with my forecast of 2.0%-2.25%. For 2014 it is even more bullish, estimating 3.0%-3.5% growth compared with my forecast of 2.0%-2.5%. The Fed also lowered its inflation forecast and significantly lowered its expectations for the unemployment rate, one of the announced key drivers of Fed policy."

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About Author

Dave Sekera, CFA  is a senior securities analyst with Morningstar.

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