What Do Freediving and the Fixed Income Market Have in Common?

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December 4, 2013
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Ahhhh, behold the holidays.

A time of hustle and bustle, feasting and imbibing, and friends and family (sometimes in that order!). It is quite likely that no other 8-week period throughout the year consumes as much energy, emotion and money as the time from Halloween through New Year’s. And we lament how quickly the time goes, as if we inadvertently stepped into Mr. Peabody’s WABAC time machine and somehow missed days, if not weeks. On this occasion, perhaps such a trip would be of use to review the fixed income markets in 2013 to set the stage for the year ahead. Alas, it will be 2015 before long…

We left 2012 holding our collective breaths - freediving style - that the European malaise would not have a significant global impact, that any compression in global growth would be contained by time and location… and be short lived. Such was the case as the US economy grew briskly in the second and third quarters. Other regions performed relatively well for most of the first half of 2013. However, the diabolical market forces at play in early May pushed yields on US Treasury securities to extremes as the 10-year Treasury yield touched 1.60%. Ongoing asset purchases from the Federal Reserve and other central banks seemed to suggest that such low yields were justified. Notably, the Bank of Japan embarked on an aggressive “reflation” program designed to stem years of stagnant growth and disinflation.

In mid-May Fed Chairman Bernanke suggested that the Fed may begin to taper its asset purchase program in the near future if the economy performed as they expected. This caused a bout of market indigestion as investors sold Treasuries across all maturities, pushing yields up. It was only a matter of weeks before the 10-year Treasury yield crossed 2.75%. Concurrent to this action was a fiscal impasse in the making – Congress was unable to pass a budget as the 2013 fiscal year end drew to a close. And the US Treasury had reached the statutory debt ceiling earlier in the year, relying on extraordinary measures to continue funding the US government. The uncertainty of a fiscal resolution, and very mild inflation numbers, led the Federal Reserve to maintain its asset purchase in September, despite most market watchers expecting a shift to tapering the asset purchase program. Short term Treasury yields were whipsawed as investors fretted over a potential default by the US Treasury in early October. An 11th hour agreement allowed the Treasury to continue borrowing and yields immediately fell back. However, the Fed was faced with a new challenge – distinguishing between a taper of the asset purchase program and an outright lifting of short term interest rates; for the market had come to view the taper as the introduction of tightening.

The Fed tinkered with a few of its newly developed policy tools in 2013. Specifically, the Fed began a repurchase agreement program as an alternative to outright asset sales when it chose to reduce the size of its nearly $4 trillion balance sheet. The program is designed to help control short term rates and manage liquidity more directly. Also, the rate of interest the Fed pays on excess reserves (IOER in market lingo) is a relatively new tool that allows the Fed to adjust how much interest it pays on deposits. Both of these tools could be – and likely will be – replacements to the Federal Funds rate mechanism, which has diminished in relevance.

President Obama has nominated – and the Senate is expected to confirm – Janet Yellen as the next Chairperson of the Federal Reserve. Ms. Yellen’s policies and outlook are similar to Bernanke’s – favoring lower unemployment while accepting a slightly higher inflation rate. She will have her hands full with continued fiscal uncertainty: Congress’s budget stop-gap and debt ceiling will come to a head shortly after she takes office in January. She will also need to manage the “Taper is not Tighten” message effectively, presuming the Fed won’t raise short term rates until 2015, as they currently estimate.

Therefore, we end 2013 holding our collective breaths that the fiscal headwinds do not have a significant and long-lasting effect on the US economy, or short term interest rates as we near the budget /debt ceiling deadlines and tapering announcement.

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