Federal Reserve Chairman Ben Bernanke today told the world what we already knew: The U.S. economy is gradually improving, and if this improvement continues, the Fed will begin tapering off its bond-buying stimulus program, possibly this year.
Bernanke set this all up on May 22, giving the markets just enough of a peek at the policy to send investors into shivers. Today he embellished on the path we knew was coming: The gradual end of ‘eternal QE.’ He said:
- The economy. “Based on its review of recent economic and financial developments, the committee sees the economy continuing to grow at a moderate pace, notwithstanding the strong headwinds created by current federal fiscal policies.”
- Inflation. “Inflation has been running below the committee’s longer run objective of 2% for some time and has been a bit softer recently. … The committee expects inflation to move back to the 2% longer-term objective.”
- Interest rates. “The committee reaffirmed its expectation that the current exceptionally low range for the funds rate will be appropriate at least as long as the unemployment rate remains above 6.5% so long as inflation and inflation expectations remain well behaved.:
- Asset purchases. ” The committee has been purchasing $40 billion per month in agency-backed securities and $45 billion per month in Treasury securities. … Although the committee left the pace of purchases unchanged at today’s meeting it’s stated that it may vary the pace of purchases as economic conditions evolve.”
- Tapering and then ending the asset purchases. “The committee currently anticipates that it will be appropriate to moderate the monthly pace of purchases later this year, and that the subsequent data remain broadly aligned with our current expectations for the economy, we will continue to reduce the pace of purchases in measured steps through the first half of next year ending purchases around mid-year.”
My reaction: About time.
This is s pretty cautious approach by the Fed, keeping short-term interest rates extremely low into probably 2016 and continuing its bond purchases for the time being, gradually tapering them down later this year and ending them in 2014. In other words, the Fed will lock short-term rates down, but will allow mid- to longer-term interest rates to begin rising to a ‘more normal’ level, which would mean positive to expected inflation.
If that happens, TIPS yields will need to also rise, probably to the ‘more normal’ yields (plus inflation) of maybe 0.5% for a 5-year, 1.5% for a 10-year, and 2.5% for a 30-year. That would be a painful transition for holders of TIPS mutual funds and TIPS traders, but it would be fantastic for net buyers of TIPS, the buy-and-hold investors looking to preserve capital into retirement.
The market’s reaction: Horror.
Bernanke began speaking at 2:30 p.m. and he had an immediate negative effect on stocks, bonds and even gold. This chart shows exactly what happened, comparing the one-day returns for the S&P 500 (SPY), TIPS ETF (TIP) and gold ETF (GLD):
I keep repeating, ‘None of this was a surprise.’ But the stock, bond and gold markets seem to be living in that Fed-fantasy world of eternal QE. It’s time to get off the bond-buying methadone and bring yields back to reality.
Thursday’s 30-year TIPS reissue. Things are shaping up very well for buyers, with the likely yield rising to about 1.25%, plus inflation. Remember that this TIPS, CUSIP 912810RA8, first auctioned four months ago with a yield of 0.639% and a coupon rate of 0.625%. That means Thursday’s buyers will snag this TIPS at a massive discount, paying about $84.20 for $100 of value.
Of course, yields may be rising in the future and that discount could get even more extreme. But this is the most attractive TIPS auction in about 18 months.
I’ll probably pass on the 30-year (maturity is too long) and hope this trend continues for the new issue 10-year TIPS coming in July.