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The Fed’s All Tapered Out

6 November 2014 in Trading Ideas

While Japan’s central bank has decided to double down on quantitative easing, the US Federal Reserve is taking its main chip off the table.

Last week, the Fed said it would conclude its bond-buying program, ending one of the bank’s signature post-financial crisis programs.1

The Fed still plans to keep short-term interest rates near zero “for a considerable time,” and it said it would replace maturing bonds to keep its holdings at about $4.5 trillion.

However, the bank was also clear that ending this round of QE meant that it saw improved labor market conditions. In addition, the Fed sought to play down concerns about the slow pace of inflation, saying that the likelihood of persistently low inflation has actually diminished since earlier this year.

While the true impact of the Fed’s bond-buying over the past six years is up for debate, most experts believe the campaign helped to fuel one of the longest bull markets in US history, with the S&P 500 having climbed more than 131% since the first round of purchases started in late 2008.

As the Wall Street Journal pointed out, it also helped to suppress borrowing costs, taking the 10-year Treasury yield to 2.32% from 2.96%, even as the economy improved.

Perhaps more importantly, however, dire predictions of Fed critics never materialized. Some of the Fed’s own officials and economists warned that bond purchases would devalue the dollar and drive up inflation. But so far, that hasn’t happened.

As the Journal explained, part of that is because, as lukewarm as the US economic recovery has been, it has outperformed other parts of the world. As a result, the US dollar has strengthened and a more legitimate concern is now whether prices are rising too slowly.

Indeed, the difference between yields on US two- and 30-year debt have fallen to almost their lowest level since 2012 on speculation that the Fed will raise interest rates next year even though inflation remains restrained.2

“The Fed is moving incrementally closer to tightening, but the long-term securities are outperforming both on the view inflation is not going to be a risk anytime soon, and relative value against our global counterparts,” Thomas Simons, a government-debt economist in at Jefferies Group, one of 22 primary dealers that trade with the Fed, told Bloomberg.

“It’s funny to think of Treasuries as relatively high-yielding, but they are when you look at high-grade European debt.”

That flattening yield curve has also hampered investments expected to gain by higher long-term interest rates. The Fed Tapering motif is up 2.1% so far in 2014. During that same time, the S&P 500 has increased 11.3%.

Over the past month, the motif has risen 7.0%; the S&P 500 has gained 3.1%.

While long-term interest rates have perked up in the past couple of weeks, investors are left to decide how much further they’ll go barring evidence of inflation – regardless of the Fed’s helping hand.

1Binyamin Appelbaum, “Federal Reserve Caps Its Bond Purchases; Focus Turns to Interest Rates,” nytimes.com, Oct. 29, 2014, http://www.nytimes.com/2014/10/30/business/federal-reserve-janet-yellen-qe-announcement.html?module=Search&mabReward=relbias%3As&_r=0, (accessed Nov. 3, 2014).

2Bloomberg News, “Yield Curve Near 2-Yr. Low On Fed, Low-Inflation Views,” investors.com, Oct. 30, 2014, http://news.investors.com/investing-bonds/103014-724280-yield-curve-near-2-yr-low-on-fed-low-inflation-views.htm, (accessed Nov. 3, 2014).