The month of August stands out mostly for its vacations, which lead to thinly traded markets, often handled by junior staff members. Of course, we've also seen the month produce volatile and gutwrenching results. Russia acted in a very un-European way and defaulted in August 1998. The United States almost accomplished the same thing two years ago when politicians in Washington butted heads over the debt-ceiling limit—also in August. And investors endured a few rocky days at the end of last week. But looking ahead, we see few issues with the same potential to ignite an investment firestorm before Labor Day.
The Federal Reserve's annual gathering in Jackson Hole, Wyo., could raise eyebrows, particularly since the September meeting of the policy-setting Federal Open Market Committee (FOMC) may feature a decision to trim asset purchases. However, in what looks like an early sign of a changing of the guard, Chairman Ben Bernanke will miss the conference. Vice Chairman Janet Yellen, the leading candidate to replace Bernanke, may speak. But she's moderating a panel discussion and may not find the opportunity to address monetary policy.
We believe investors have focused almost entirely on the "will they or won't they" decision—about the possibility of starting to taper the Fed's monthly purchases of $85 billion in U.S. Treasuries and mortgage-backed securities—with very little thought about the path the process will take. Could the market have become too contented?
At the June FOMC meeting's press briefing, Bernanke said when the tapering process concluded— meaning when the Fed stopped purchasing assets—the unemployment rate probably would have dipped to about 7%. With unemployment reaching 7.4% in July, recent patterns suggest we could see a 7% unemployment rate somewhere near the start of 2014. After its September meeting, the FOMC will convene twice more this year, then meet again in January. By the time of that January meeting, unemployment may have fallen to the 7% threshold.
The January FOMC meeting could represent the decision point to end asset purchases, meaning the Fed will have gone from buying $85 billion in bonds per month to zero in less than five months. While central bankers have not articulated their tapering strategy, we believe investors expect bond purchases to persist well into 2014. We've heard mid-year mentioned frequently as a target.
Investors have become comfortable with the idea of the Fed starting its tapering in September. But we do not believe that investors have taken full account of the prospect of a rapid reduction in bond purchases. If Fed policymakers believe that their 7% unemployment target is truly significant, they have a responsibility to communicate their intentions. However, even if the Fed spotlights its unemployment target, a quick end to tapering probably will spur volatility. Emerging markets and lower-grade credit markets suffered when the Fed first promoted the idea of tapering, and new revelations about the timing could lead to another rough period. Such weakness could easily extend to the broad equity markets, which also struggled in the spring.
Of course, the Federal Reserve will consider more than just the unemployment rate. To accelerate the tapering process, the bankers must feel comfortable with other facets of the economy. A quicker-thanexpected slowdown in asset purchases would likely boost interest rates, creating new complications. The housing market already saw modest adverse effects from the initial pop in rates during the spring. Mortgage refinancing dried up and, while homes remain affordable, the sudden rise in rates unnerved many potential homebuyers.
Business investment shows signs of picking up, and indicators such as the Institute for Supply Management manufacturing and non-manufacturing indices of purchasing managers' sentiment have risen. The Citigroup Economic Surprise Index for the U.S. has reached its highest level since last December, suggesting that economic reports in 2013 generally have been better than expected. Corporate earnings continue to rise, but the quality of these earnings leaves much to be desired, given the lack of consistent revenue growth.
Finally, the Fed won't want to start reducing its purchases, then be forced change course because it didn't properly assess the impact of the decision. Market volatility could lead to a loss of confidence, which in turn would slow economic activity—a progression that might cause investors to conclude the central bank doesn't know what it's doing. For that reason, investors should expect deliberate, clear communication to prepare markets for a policy transition.
We fear investors have become complacent, perhaps lulled by the easy summer breezes. Despite the lack of concern, the Fed faces a complex task as September approaches and the leaves begin to turn.
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