Tag Archives: interest rates

(Revised) Interest rate liberalization in China

China’s top officials made New Year resolution to bring about economic overhaul. At the Boao Davos Forum, Premier Li Keqiang emphasized that the government won’t panic in the face of slowing growth. Some analyst says that the slowing growth means that difficult reforms will be put off indefinitely. But easier one such as the interest rate reform is unwinding. The People’s Bank of China is in its final stages of winning approval for a bank deposit insurance system.

Interest rate liberalization in China is long overdue. But once it is implemented successfully, it will put money in the pockets of ordinary Chinese savers, make the banks evaluate risks more carefully, and direct lending to privately owned firms that complain of China’s largest banks ignoring them.

Yet steering the banking system of the second large economy in the world to a new direction is not an easy task. Currently, the PBOC targets a measure of bank credit called M2 and instructs China’s giant state-owned banks about their lending practices. For instance, the PBOC has told banks to halt loans to troubled real-estate developers and industries marked by overcapacity.  By contrast, other central banks take a less direct role by setting benchmark rates that offer a guidepost to banks as they lend.

 PBOC is hiring new brains to deepen their understanding of how to transform to a central bank more like other central banks. Ma Jun, until recently Deutsche Bank ‘s top China economist, was hired as the Chinese central bank’s new chief economist. He proposed a plan to liberalize the country’s financial system in steps within three years. First it needs to establish a central bank-blessed interest rate (China’s interbank rate) that would set a benchmark for lenders. That would give China the equivalent of the U.S. federal funds rate. During a first stage of reform, the PBOC should keep its intentions about the interbank market quiet and target a broader measure of money supply, known as M3. If the interbank lending system stabilized, China could shift fully to a monetary policy where the PBOC would set the interbank market rate, and banks would be free to charge what they like for deposits and loans.

But for such a plan to carry out, there are several caveats that must be factored in.

First of all, will PBOC be willing to give up control of lending by state-owned banks? Ma Jun must bear in mind the fact that it is much more easy for PBOC officials to send directives than to maneuver in a much more complicated market like Federal Funds Market.

Secondly, the biggest obstacle lies ahead for interest rate liberalization is what is known as the local government debt issue. Lots of local governments of China have been facing the risk of default on the colossal debts borrowed from state-owned banks. These debts were used to fund local governments unplanned and outrageous investment in infrastructure in order to boost local GDP growth, which is closely tied to the evaluation of local governors performance.

If the interest rate freed up too quickly, there is fear that the interest rate will be too high and local government will have to borrow more new debts to payback old debts. The huge default risk will put China’s economy in a perilous situation.The growing inability of local government to finance their debt is considered one of China’s biggest financial weaknesses. Unless there is a safer way to settle down local debt problem, I am afraid the interest rate liberalization agenda will be postponed.

(Revised) A Constantly Changing Landscape

The landscape in which financial institutions operate is very different now than it was before the financial crisis of 2008. Mergers and acquisitions between healthy firms and failing firms allowed the strong to get stronger and subsequently gain market share. As the market has grown more concentrated, it has also grown less competitive. Although competition is a corner stone of capitalism, maybe large banks help promote financial stability. Whether or not this is true, new government regulations have been enacted with the sole purpose of reducing risk taking by financial institutions.

Unable to put as much capital at risk as before, banks are shedding operations that were once major profit centers. For example, the Volker Rule bans propriety trading and limits commercial banks to hedging and market making. Return on equity (ROE), a closely watched measure of profitability, has dropped from double digits to single digits for most banks and I believe this is representative of increased regulation. Higher capital requirements mandates that a significant portion of cash is set aside. Essentially, cash must be tied up as an unproductive asset (rather than being put at risk in order to earn a return).

While some aspects of bank operations have been forced to shrink (or be eliminated), an area of growth for banks has been in commercial lending (i.e. lending to businesses). According to the Wall Street Journal, “Lenders, too, are making bigger bets on an economic expansion at a time when tighter restrictions on many banking functions have placed more importance on core lending activities to boost earnings”. Although banks might have preferred riskier operations in order to earn a higher return, more lending to businesses is certainly better for economic growth. In addition to being less risky than certain activities such as proprietary trading, lending is a vital source of credit that promotes booming business cycles.

The increase in lending to business has been a two way street. According to the Wall Street Journal, “The rise is being driven both by banks, which are loosening their lending standards, and companies, which are seeking more money, bank executives said”. On the one hand, companies are seeking cash. If businesses use this cash to cover day-to-day expenses (i.e. meeting current obligations), then this might not mean so much for economic growth. If businesses use this cash for capital expenditures (i.e. long-term investments in equipment), then this businesses might be indicating a positive outlook for economic growth. On the other hand, banks very much want to lend the cash as evidenced by lower lending standards. Although increased availability of credit is important for economic growth, an over-leveraged can easily fall into a financial crisis. According to the Wall Street Journal, “And while relaxed standards aren’t likely to cause banks much trouble in the near future, it was reckless lending that helped fuel the financial crisis”. As long as commercial lending is monitored correctly, then the risk should be manageable.

Although banks have increased lending to businesses, the same cannot be said for lending to consumers. In order to reverse this trend, banks have loosened standards for homebuyers. According to the Wall Street Journal, “Mortgage lenders are beginning to ease the restrictive lending standards enacted after the housing boom turned to bust, a sign of their rising confidence in the housing market”. A meaningful re-acceleration of the housing market is crucial for justifying expectations for economic growth. Although the housing market seemed to heat up last year, it slowed down in the fourth quarter and the first quarter of this year. Although one factor contributing to the slowdown might have been the winter weather, rising interest rates also certainly played a role. Higher interest rates decrease affordability for homebuyers.

Changes in interest rates have significant implications for both borrowers and lenders. According to the Wall Street Journal, “Some banks said the prospect of rising interest rates in the next few years could spur additional growth in commercial lending”.  Rising interest rates make lending more appealing for a few reasons. First, creditors get to collect higher interest payments. At the expense of debtors, banks earn increased revenue from lending activities. Second, many financial institutions have a mismatch between asset and liability maturity structures. Banks’ assets are mainly long-term loans and their liabilities are mainly short-term deposits. When interest rates rise, the value of the assets decrease more than the value of the liabilities. Banks can hedge interest rate risk and realign asset and liability maturity structures through commercial lending.

I cannot help but be concerned when I hear banks are lowering their lending standards because I am reminded of bank conduct during the housing bubble. I can only hope that regulators are watching more closely this time.

Commercial Lending on the Rise

Since the financial crisis, the climate has been constantly changing for financial institutions. Bankruptcies allowed banks to grow in size as healthy banks absorbed failing banks. Since then new regulations have been imposed on the largest financial institutions changing (and in some cases eliminating) many of their most profitable operations. For example, the Volker Rule bans   propriety trading by commercial banks. Return on equity (ROE), a closely watched measure of profitability, has dropped from double digits to single digits for most banks and this is representative of increased regulation. For example, higher capital requirements mandates that a significant portion of a bank’s capital is tied up being unproductive rather than being put to use (i.e. put at risk in order to earn a return).

While some aspects of bank operations have been forced to shrink (or be eliminated), an area of growth for banks has been in their lending to businesses. According to the Wall Street Journal, “Lenders, too, are making bigger bets on an economic expansion at a time when tighter restrictions on many banking functions have placed more importance on core lending activities to boost earnings”. Although banks might have preferred to continue running certain risky operations such as proprietary trading, I think the increase in lending is is more beneficial for economic growth. In addition to being less risky than certain activities such as proprietary trading, lending is an vital source of credit that can promote booms in business cycles.

The increase in lending to business has been a two way street. According to the Wall Street Journal, “The rise is being driven both by banks, which are loosening their lending standards, and companies, which are seeking more money, bank executives said”. On the one hand, companies are seeking cash. If businesses use this cash to cover day-to-day expenses (i.e. meeting current obligations), then this might not mean so much for economic growth. If businesses use this cash for capital expenditures (i.e. long-term investments in equipment), then this might indicate a positive outlook for economic growth. On the other hand, part of the jump in lending is due to banks lowering their standards. Although increased availability of credit is important for economic growth, an over-leveraged can easily fall into a financial crisis. According to the Wall Street Journal, “And while relaxed standards aren’t likely to cause banks much trouble in the near future, it was reckless lending that helped fuel the financial crisis”. I agree that we are far from the dangerous lending that occurred prior to the financial crisis, however, I hope a minimum level of lending standards can be maintained so that we avoid another financial disaster.

Although banks have increased lending to businesses, the same cannot be said for lending to consumers. In order to reverse this trend, banks have loosened standards for home buyers. According to the Wall Street Journal, “Mortgage lenders are beginning to ease the restrictive lending standards enacted after the housing boom turned to bust, a sign of their rising confidence in the housing market”. A meaningful re-acceleration of the housing market is crucial for justifying expectations for economic growth. Although we had a nice pop last year, the housing market slowed down in the fourth quarter and the first quarter of this year. Part of the slowdown might have been due to weather as well as the rising interest rates.

Rising interest rates making lending more appealing for a few reasons. According to the Wall Street Journal, “Some banks said the prospect of rising interest rates in the next few years could spur additional growth in commercial lending”. First, higher interest rates help creditors and hurt debtors. Although debtors must make higher interest payments, creditors get to collect higher interest payments. Second, many financial institutions have a mismatch between asset and liability maturity structures. Banks’ assets are mainly long-term loans and their liabilities are mainly short-term deposits. When interest rates rise, the value of the assets decrease more than the value of the liabilities because longer duration securities are more sensitive to changes in interest rates. Making more commercial loans enables banks to realign asset and liability maturity structures.

Relaxed Borrowing

It no question that a big cause of the 2009 recession was the sub prime mortgages banks were practically giving away. After the collapse there was a lot of talk of moral hazard, and the banks playing fast and lose with everyone’s money. With the bailouts came tighter regulation, sub prime mortgages disappeared and it borrowing standards became tighter. Now almost five years later it appears that standards are beginning to lighten up.

Mortgage production has stalled, and aside for a quarter at 2011, is lower than its ever been since 2009. In response the banks have began to lower the borrowing standards. Is this the first step back down a slippery slope or are the banks regaining confidence in the market?

After an initial pass through of the article I believed that this was the start back down a slippery slope. The banks were making less money than used to and saw a way to profit by lowering borrowing standards. It seemed all to familiar, the banks trying to make more and more money by making riskier bets. It wasn’t a sub prime mortgage but it looked like the start of them returning. After the initial read I did some research on historic mortgage rates to see just how risky the banks were being.

To start I looked at the average credit scores for those new mortgages over the past ten years. As you can see from the chart below, scores below 620 were accepted at a rate of almost 10% around the collapse. After, it took about a minimum score of 640 to be accepted for a mortgage. No banks have a standard credit score when evaluating candidates, however it is unlikely that banks are going back to the 620 standard seen before.

.BN-CB011_score_G_20140322121456

 

Another piece of information for evaluating how stringent banks are being is the percent down payment they require on each loan. Down payments vary depending on other factors but after the housing collapse banks were requiring as much as 20% down on homes. In the past year rates have been dropping below 10% and some lenders are moving below 5%, with a good credit score that is. These numbers don’t seem very different than those in 2009 when the housing market collapsed.

So it may seem that banks are loosening their standards. However this isn’t something that is anywhere as risky as the sub prime mortgages of 2009. The banks are remaining stricter on the credit scores to ensure that the loans aren’t defaulted on. So with the banks lowering standards, it is likely a better sign of a strong economy over a moral hazardous financial industry.

 

The Dangers of Low Volatility

On Monday, I discussed March retail sales and that its strength might be a positive sign economic growth. Today, there is more good news for the U.S. economy. According to the Wall Street Journal, “U.S. industrial production rose in March, moving beyond a lackluster winter and showing potential to gain strength in coming months”. Industrial production gauges the output of U.S. mines, manufacturers, electric and gas utilities. The manufacturing sector is only a fraction of domestic economic activity since the U.S. has transitioned to a service oriented economy. Nonetheless, many economists consider it to be an indicator of future demand.

In fact, economic activity across the United States is picking up steam. According to the Wall Street Journal, “Overall, the latest beige book, which describes economic conditions across the central bank’s 12 districts, pointed to an economy that was getting back on track after growth slowed earlier in the year”. This report, which is two weeks before the Fed’s April policy meeting, will likely have an impact on monetary policy. As the Fed continues to reduce asset purchases, the prospect of rising interest rates becomes more of a reality.

However, the Fed must watch the level of inflation when making its decision about interest rates. Even though economic activity is picking up, inflation is remaining stubbornly low and is a source of concern for the Fed. According to the Wall Street Journal,

Price gains could provide some comfort to Fed policy makers as they debate whether to keep pulling back on their easy-money policies meant to spur growth. Consumer inflation has run below the Fed’s 2% annual target for nearly two years, but price gains have accelerated a bit recently. Some central-bank officials have been concerned that low inflation—which discourages businesses and consumers from spending—could persist and weigh on growth.

Low levels of inflation are being experienced around the world. For example, the Bank of Japan is conducting asset purchases with the sole purpose of creating inflation. For this reason, the Fed can continue tapering at a slow pace as this should help push up inflation.

The problem with low inflation is it might be a symptom of something larger. We are starting to see the United States as well as other countries enter a stable path of growth. In addition, volatility is at very low levels. The last time we had a similar situation was during the Great Moderation. Starting in the mid-1980s, major economic variables such as gross domestic product (GDP) growth began to decline in volatility. In economics, the  “Great Moderation” refers to how stable the business cycle was at that time. We are again seeing that stable path of growth and global inflation, which is coinciding with an approaching of all-time lows again on volatility. However, this situation is easily disturbed. The first time around it masked a bubble in the housing market and that ended in a financial crisis. I am not sure what it is masking this time.

Delaware: incorporate for the taxes, stay for the arbitrage

cooperecon-fig10_004

A little known court ruling in Delaware from 2007 has had some big consequences.  While it has provided some benefits for investors, it also results in the inefficient use of resources, increased costs for mergers and acquisitions, and arbitrage.  After examining the source of these effects, it may be possible to reduce the costs while keeping the benefits.

The case, which found that a shareholder could vote on a proposed deal if they held stock on the date of the vote, as opposed to the date of record (when the offer was made). This has allowed hedge funds and activist investors to take positions in a target companies after a deal price has been announced, then vote stop the deal in order to determine a fair price through what is called an appraisal.  This has resulted in what is known as appraisal arbitrage. While this plan can backfire if the judgement decreases the price, professional investors are in as good a position as anyone to decide whether a price is too low, and there is an additional incentive that mediates the cost of the appraisal and the possibility off loos.  However this outcome is actually quite rare: 80% succeed in getting a higher price.

Hedge funds argue that investors can actually be made better off by these deals because it allows bad deals that would have otherwise gone through to be recognized by professionals and provides an avenue to rectify the situation (with interest!).  Recent examples in the news demonstrate this. The threat of appraisal by Carl Ichan didn’t prevent Dell from going private, but it did secure a higher price per share for investors. Currently, Dole is in court over its acquisition last year being too low, and Darden Restaurants is currently dealing with Starboard Value LP, a hedge fund who wants to stop the sale of its Red Lobster Chain of restaurants.

While such actions by activist investors and hedge funds have made investors better off in the past, it’s called arbitrage for a reason.  Once the case arrives in court, the price is arrived at via the discounted cash flow method.  According to David A. Katz, a partner at Wachtell, Lipton, Rosen, and Katz, “Discounted cash flow analyses, however, often produce values in excess of what a buyer would be willing to pay or the value of the company’s stock in the public trading markets.”  In addition to the inflated measure of value the company has to pay 5.75% interest on the judgment, even if the original price is found to be fair.  This amounts to a practically risk free profit if the deal was even close to fair to begin with.

Appraisal arbitrage can be seen as less an economic issue and more of a legal anomaly.  To fix this problem, while preserving the economic benefit for consumers, the court should allow for the use of whatever valuation method is most appropriate to the company in question.  Most importantly, it must reduce the interest rate that it pays on the judgments to be pegged to treasuries to end the arbitrage opportunity.  In this way, activists and funds will intercede only when investors need them most.

 

 

 

 

 

Inflection Point for U.S. Economy: And Perhaps the World

The United States economy seems to be at an inflection point in which growth will either accelerate above the trend or remain below. The March Employment report had some very positive signs, which showed that more people are finding jobs. According to the Wall Street Journal, “All of the gains came from private companies, which added 192,000 jobs. The March gain means the private sector has regained all the positions lost in the recession”. Although the 192,000 jobs added was just below forecasts, I think it is a strong number that proves the December and January employment reports were outliers that were negatively impacted by severe winter weather. The recovery has been painfully slow in the labor market, but the March employment report was a significant step in the right direction. The better level of hiring, as evidenced by the March employment report, will hopefully give a boost to consumer confidence and in turn support consumption expenditures.

According to Ray Dalio, credit expansion and credit contraction essentially determine booms and busts in economic business cycles. Following many years of expansion, the credit market collapsed in the recent financial crisis. Thus, the health of private credit markets is central to the current inflection point of the U.S. economy.

fredgraph_credit

As seen above, the year over year percent change in private credit has recently turned in the right direction. If credit markets continue to strengthen, households will be able to take on more leverage. An improvement in private credit conditions is indispensable to supporting the positive signs in the March employment report.

If the March employment report was so lovely and credit conditions are improving, then why the recent dip in financial markets? I believe changing expectations about future interest rates played a significant role. Expectations about interest rate increases are mid-2015 (i.e. 6 months following the end of quantitative easing) and there are concerns surrounding what the impact will be on each sector of the U.S. economy. On the one hand, financial stocks moved up on the news as they stand to earn more interest revenue from loans. On the other hand, sectors sensitive to interest rates (ex. Housing) will likely suffer when rates move up at first. For example, higher interest rates decrease affordability in the housing market and could potentially lead to decreased residential investment. A key rate to watch is the ten-year Treasury yield, which is usually considered the risk-free rate for long-term debt and is thus intertwined with many other rates.

fredgraph_10yr

The yield on the ten-year Treasury has tested 3%, but has remained below it. I believe it is only a matter of time before the 3% level is breached. As mid-2015 approaches, expectations about future rates will need to be fully priced in. As a result, a first test for the inflection point will be whether sectors that are sensitive to interest rates can handle higher rates. If all of this goes smoothly, then the United States economy could reach escape velocity and grow above the cyclical trend of 2.5%. Wonderful! Not so fast… According to the Wall Street Journal,

If the U.S. grows a half-percentage point faster than expected, it would force the Federal Reserve to raise interest rates at a quicker clip. That would boost borrowing costs for emerging markets more than many governments and investors planned, raising serious questions about the ability of countries, households and corporations to pay off their debts.

Although I am hoping for stronger economic growth in the United States, I was unaware that it might cause problems for the rest of the world. To be clear, the IMF is expecting the U.S. economy to expand at 2.8% this year and 3% in 2015. I am not sure how likely the U.S. is to grow above these levels, but I am very pleased by the signs in the labor and credit markets. Hypothetically, if U.S. economic growth takes off, then the Fed must respond quickly and effectively with higher rates despite a negative impact on the rest of the world. As the Fed demonstrated during the major sell off in emerging markets this year, the Fed’s mandate is the U.S. economy and so it must keep its focus here.

Yellen Attempts to Control Expectations

Interest rates rose following the March Federal Open Market Committee (FOMC) meeting in which the Fed eliminated the quantitate thresholds for unemployment and inflation from forward guidance. Without these thresholds, financial markets were left in perplexing uncertainty regarding the timing of interest rate hikes. Particularly, markets speculated as to when rates would rise once the Fed completed tapering its asset purchases. Although the FOMC statement provided an extremely vague time period, Yellen seemed to define the time period to be precisely six months in the post-FOMC press conference.

Unfortunately, financial markets misinterpreted Yellen’s words to be more exact than she intended. Prior to the March FOMC meeting, expectations for a first rate hike were in late 2015 or early 2016. According to the Wall Street Journal, “Some investors had taken Ms. Yellen’s remarks at a news conference after that [FOMC] meeting to mean rate increases might come sooner than they expected”. After the March FOMC meeting, yields on the two-year and five-year treasury adjusted to price in a rate hike around mid-2015 (i.e. about 6 months following the projected conclusion of the Fed’s tapering).

fredgraph2yrTreasuries fredgraph5yrtreasuries

As seen above, the two-year treasury yields had their largest single-day move since 2011 and the five-year treasury yields had their largest single-day move since September 2013 and rose the most since June 2013. The two-year and five-year treasury yields rose to reflect changes in expectations about the future.

In a speech on Monday, Yellen attempted to diminish these expectations to stop yields from moving higher. Yellen offered five reasons why she still sees slack in the economy. First, the number of involuntary part-time workers remains elevated. Second, statistics on job turnover is very low. According to the Wall Street Journal, “[Low job turnover] is an indicator that people are reluctant to risk leaving their jobs because they worry that it will be hard to find another”. Third, wage growth since the financial crisis has been low by historical standards. Fourth, a significant portion of the unemployed has been out of work for six months ore more. According to the Wall Street Journal, “The concern is that the long-term unemployed may remain on the sidelines, ultimately dropping out of the workforce”. Fifth, the proportion of working-age adults that hold or are seeking jobs (participation rate) has continued declining since the recession and throughout the recovery. Yellen believes these signs of slack in the economy give the Fed room to keep interest rates low.

Yellen also attempted to reshape the perspective on tapering. According to the Wall Street Journal, “She emphasized that the Fed’s recent decisions to reduce the size of its bond-buying program, meant to keep long-term interest rates low to spur growth, shouldn’t be viewed as a withdrawal of support of the economy. Rather, she said the Fed is adding support at a lower pace”. Although some might view the tapering of asset purchases as a withdrawal of stimulus, Yellen prefers the perspective that it is only a decrease in the rate by which stimulus is growing. Furthermore, monthly asset purchases themselves do not stimulate the economy. Instead, the size and duration of the Fed’s balance sheet (i.e. balance sheet monetary policy), which the Fed will maintain even after it stops expanding, will continue to stimulate the economy. As a result, financial markets should not be concerned that the Fed’s tapering is representative of tightening monetary policy.

Despite Yellen’s dovish message, treasury yields have not fallen to their pre-FOMC meeting level. I am not surprised by this because treasury yields were quite low before and are now adequately pricing interest rate risk. Although interest rates might not rise in early 2015, I think rates will start rising by late 2015 and this is reflected in the current level of the two-year and five-year treasury yield.

Struggling PIMCO Takes Another Hit to Trailing Bond Fund

PIMCO (Pacific Investment Management Company, LLC), the global fixed income investment behemoth, has had a hard year. It’s flagship bond fund (and the world’s largest bond fund), the Pimco Total Return Fund, is currently on track this quarter to underperform 87% of its peers. As Min Zeng of the Wall Street Journal explains, the $236.5 billion fund had only a 1.28% year-on-year total return according to data from the fund tracker Morningstar. Pimco’s Total Return Fund falls well short of the standard bond benchmark, the Barclays U.S. Aggregate Bond Index, which reportedly returned 2.03% over the same period.

A number of factors have negatively impacted PIMCO’s success in the past year. In January, in a high-profile management struggle PIMCO’s chief executive Mohamed El-Erian stepped down after the firm’s bond funds stumbled and investors fled from the firm. In 2013 investors withdrew a net $41.1 billion from the Total Return fund, which was a mutual-fund industry record. The firm also appears to be riding the wrong wave, as the Fed has begun unwinding its Quantitative Easing policy, namely by decreasing U.S Treasury Bond purchases and signaling that interest rate increases are likely to arrive soon. As Jon Hilsenrath of the Wall Street Journal writes, many Fed officials believe that the central bank will increase rates soon, perhaps as soon as the end of the year. In addition, Janet Yellen, the Fed Chairwoman, has hinted that an increase in the Fed funds rate could come soon as well. Evidence of increases to interest rates has already begun to accumulate, as the U.S. Treasury yield curve, a plot of current interest rates of bonds at different maturities, has already shifted upwards in the past month. Screen Shot 2014-03-29 at 9.15.12 PMIn order to flatten out the yield curve, interest rates for 5 year and 10 year U.S. treasury bonds are increased. Since bond prices and interest rates move in opposite directions, this could be done by decreasing the price of bonds, which would occur if the Fed reduced the rate at which it purchased these bonds (demand for these bonds would go down, as would the price, and therefore the interest rate would increase). If we look at the Fed’s current holdings of U.S. Treasury bonds with yields around 10 years, we find that there is evidence that the Fed has reduced its purchases of bonds at this maturity. Here, we see the size of the Fed’s portfolio of 5-10 Year U.S Treasury bonds hasn’t changed much in the past year. Screen Shot 2014-03-29 at 9.31.29 PM

 

With interest rates set to rise, and bond prices therefore set to fall, PIMCO’s current investment manager Bill Gross is likely sweating bullets. However, Mr. Gross has weathered storms before at the helm of the Total Return fund, as he’s maintained a 5-year average annualize return of 6.9%, which is well above the benchmark’s 4.89% and above 55% of its peers. Only time will tell if Mr. Gross’s experience will be able to change the fortunes of his flagship fund in the face of turbulent bond markets ahead.

Fed Meeting: Staying the Course Spooks Markets

During the meeting of the Federal Reserve today, there were no surprises. According to the Wall Street Journal, “The Fed took several actions at the meeting. First, it pulled back to $55 billion from $65 billion its monthly bond-buying program, which is aimed at holding down long-term interest rates in hopes of boosting spending, hiring and growth. It was the third reduction in the bond purchases since December”. Asset purchases, which have been reduced from $85 billion a month, are on pace to be finished this coming October. Tapering and the ending (in the growth of) asset purchases was already priced into the market before the Fed’s meeting. In short, tapering is old news. Although asset purchases will likely be done in October, it remains to be seen how the Fed unwinds its massive balance sheet.

The Fed made some (relatively) more exciting changes with respect to forward guidance. According to the Wall Street Journal, “The central bank also rewrote its guidance about the likely path of short-term interest rates, putting less weight on the unemployment rate as a signpost for when rate increases will start”. As the unemployment rate has decreased to 6.7%, the 6.5% threshold for unemployment has become a less significant data point for policy makers. Furthermore, limitations of the unemployment rate have made it less meaningful as an indication of conditions in the labor market. I have mentioned in previous blogs that changes in the unemployment rate were not accurately portraying underlying conditions in labor markets . For example, an increase in the labor-force participation rate pushed the unemployment rate up to 6.7% in the last employment report. Although an increase in the labor-force participation rate is perceived as good, an increase in the unemployment rate is seen as bad. According to the Wall Street Journal, “It said instead [of the 6.5% unemployment threshold] that the Fed would look at a broad range of economic indicators in deciding when to start raising short-term rates from near zero, where they have been since December 2008“. Therefore, I believe it was a good decision to ditch the unemployment threshold in favor of a larger set of economic indicators.

In addition, the Fed reconfirmed its forward guidance on interest rates. According to the Wall Street Journal, “The Fed took several steps to assure investors that interest rates won’t rise soon and that when rates do start rising the increases will be gradual and limited. For example, the Fed’s official policy statement included a new line noting that officials expect to keep rates lower than normal even after inflation and employment return to their longer-run trends“. Although this policy has been understood for some time, the Fed has finally decided to state this unambiguously. As the Fed continues to taper, most people assume that rate hikes will follow – the question is how soon they will follow. In addition to other factors, the inflation rate is going to be important in determining when interest rates will rise. If inflation remains below target, then rates will remain low long after the bond buying ends.

However, financial markets fell today – possibly due to what was said during the Fed’s meeting. According to the Wall Street Journal, “Even though the Fed’s official policy statement sought to give assurances of continued low rates far into the future and Ms. Yellen played down rate-increase expectations, stock prices fell and longer-term rates on Treasury bonds moved up”. Despite the lack of surprises, the Fed’s meeting managed to somehow cause worry among investors.

Apparently, the source of concern was regarding the perception of imminent rate hikes. According to the Wall Street Journal, “In a press conference after the meeting, Ms. Yellen suggested that interest-rate increases might come about six months after the bond-buying program ends – a conclusion that could come this fall”. Financial markets were not anticipating interest rates to increase in early 2015. After many years of aggressive expansionary monetary policy, the financial markets have become very sensitive to interest rate decisions.

Today’s Fed meeting essentially affirmed that interest rates will begin rising in 2015. Considering that asset purchases will likely end in October 2014, interest rate hikes in 2015 might seem sudden to financial markets. Regardless, I believe interest rates will begin rising in 2015 so financial markets might as well begin pricing that in. According to the Wall Street Journal, “Ten of 16 officials saw short-term rates rising to 1% or more by the end of 2015, with four of them right at 1%. Six officials saw rates below 1% by the end of 2015“. Although Ms. Yellen might have misspoke during the press conference, I think it is good that she was very clear about when interest rates will begin rising. Assuming there are no setbacks, I believe the economy is strengthening to the point where interest rates can begin to rise.