3rd Quarter 2013
The Federal Reserve surprised most investors on September 18 by continuing to purchase $85 billion a month of US Treasuries and mortgage-backed securities (MBS). Following Chairman Bernanke’s comments in May, and those of several of the Fed’s Open Market Committee (FOMC) members, the consensus amongst economists, strategists, and investors was that the central bank would likely remove a modest amount of stimulus. In fact, as Treasury yields matriculated higher, it appeared that such action was being “priced in” to the market, and justifiably so as Fed commentary aside, the nation’s unemployment rate had declined to 7.3%—very close to the “about 7%” Chairman Bernanke indicated as a critical level at which markets might anticipate the tapering of purchases. The Committee’s outlook is for economic growth to increase at a “moderate pace” into 2014. Even after the Fed amended its outlook for growth to “modest,” the scorecard still seemed in favor of tapering, so why did the committee unanimously vote to maintain the program, and why did the market score this incorrectly? In our view, there were two predominant areas of confusion—investor misinterpretation and Fed miscommunication.
When it has come to assessing and positioning ahead of this Committee’s directives, the simpler of two interoperations has consistently led to the better outcomes. Mr. Bernanke did not affirm nor deny that the September 18 meeting would result in a tapering of purchases. He was in fact, completely neutral. Although the Fed’s expectations between the future paths of key economic measures remained favorable, the divergence between the actual data and the expected data remained wide. For instance, since early 2008, real personal consumption expenditures, which accounts for approximately 70% of U.S. Gross Domestic Product (GDP), has grown at an average annual rate of 1.1%, easily the weakest period of consumer demand since the Great Depression. While the Fed may expect that longer term consumption will approach 2%, will it be able to do so when the majority of the decline in the nation’s unemployment rate is coming from a shrinking labor force, the federal government is facing a mandatory shutdown and the Federal Reserve is removing stimulus? In our view, the answer was decidedly “no.”
The second area of contention is the Fed’s communication itself. To be sure, a more transparent Federal Reserve can be very effective provided it remains consistent. Both Chairman Bernanke and the Committee have qualified their remarks as being subject to the data. This recent string of communications showed a lack of consistency, however. For example, while the Fed has been concerned about the poor mix of the nation’s labor market, it has made no such revision as to what that means for the unemployment rate as a policy toggle. Likewise, if the Fed’s views of central tendencies are skewed toward more near-term outcomes, to what extent is a reduction from “moderate” to “modest” growth material to policy decisions? Ultimately, the Committee may feel that such communications are too transparent, which may be a valid view. It is their responsibility, however, to recognize that the market has been conditioned nonetheless. As we now enter the fourth quarter, a critical factor for both the markets and the U.S. economy will be how the central bank manages expectations on these two separate fronts.
The Fund posted modest gains in performing roughly in-line with its Barclays Capital Aggregate Bond Index benchmark. Returns were driven by a strong performance in September following the Fed’s decision not to begin tapering bond purchases. Intermediate US Treasuries outperformed long-term Treasuries as the yield curve steepened, while mortgage-backed securities outperformed duration-matched Treasuries for the month as well.
Credit securities outperformed duration-matched Treasuries as well during the quarter, aiding the Fund’s relative performance. Long credit underperformed intermediate credit on an absolute basis but outperformed by 72 basis points on a duration-adjusted basis. Financials were the best performing credit subsector on a duration-adjusted basis, well ahead of Industrials, Utilities, and non-corporates. A-rated Investment Grade securities were the best performing from a quality perspective.
The fourth quarter began with a partial shutdown of the U.S. Government. The government closure will affect non-essential services such as National Parks and passport and driver’s license renewals. Economists estimate that the shutdown could cost the economy up to $2 billion dollars as roughly 800,000 U.S. Federal government workers have been put on temporary unpaid leave. According to Standard and Poor’s, the shutdown may result in a reduction of U.S. GDP by 0.3% for each week it persists.
To date, markets have had a muted reaction to the news, as this is the third time budget negotiations have gone to the wire under the Obama administration. However, one factor that will likely complicate this go-round is a statement released by the commissioner of the Bureau of Labor Statistics stating, “All survey and other program operations will cease, and the public web site will not be updated.” This would include the release of the non-farm payrolls data, an ever more critical data point for investors trying to forecast when, or if, the Federal Reserve will begin tapering its purchases of U.S. Treasuries and Agency Mortgage-Backed Securities.
Taplin, Canida & Habacht (TCH)
Note: Bond funds are subject to interest rate and credit risk similar to individual bonds. As interest rates rise or credit quality suffers, an investor is susceptible to loss of principal.
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