Unlike the wild swings witnessed in January, capital markets were relatively calm in February with the yield of the 10-year and 30-year Treasury securities effectively unchanged for the month. Similarly, equities reversed the selloff suffered in January and early February, ultimately posting a year to date total return of 0.94% through the end of the month.
On February 19th, the Federal Reserve released the minutes of the January Federal Open Market Committee meeting, the first Chaired by Janet Yellen. While the Fed had repeatedly communicated that there would be continuity in monetary policy as the Chairmanship was passed from Bernanke to Yellen, the minutes reflected otherwise. Attention had been focused on whether or not the committee would continue to reduce the pace of quantitative easing. As we wrote last month, the economy has been sputtering through a weather-related slowdown and there was some speculation that the Fed would suspend the pace of tapering in an effort to offset the slowdown. For the record, we did not share that opinion. In reducing the pace of quantitative easing, the Fed is only doing less emergency easing; in no way are they tightening policy. Surprisingly, the discussion among the policy makers was more hawkish than we had expected. What caught our eye was the statement “downside risks to the forecast were thought to have diminished, but the risks were tilted a little to the downside because with target Fed Funds at its lower bound, the economy was not well balanced to withstand future adverse shocks.” In other words, the Fed realizes that they don’t have much “dry powder” stimulus should an unanticipated shock disrupt economic growth. This has been a worry of ours for some time. When questioned about that risk, Fed policy makers have said that increased quantitative easing would mitigate such a risk. Nevertheless, they’ve been reluctant to admit that they no longer have interest rate management as a policy tool. Apparently the discussion delved far deeper into the question of interest rate normalcy. The minutes indicated that three of the Regional Presidents of the Federal Reserve were in favor of raising the Fed Funds rate “relatively soon” and specified that by targeting this summer. That’s certainly a departure from keeping rates low for an extended period of time. The shift in discussion could become more pronounced when Stanley Fischer, the Vice-Chairman nominee joins the Fed. Fischer has advocated a more reactionary monetary policy both while at the Bank of Israel and in comments since leaving that post. Under his supervision, the Bank of Israel was the first Central Bank to raise rates following the financial crisis. Recently, there has been a divide between several of the more hawkish bank Presidents and the decidedly more dovish Fed Governors. Should Mr. Fischer advocate a more balanced approach to monetary policy, the message from the Fed could soon be one of restraint.
Interestingly, despite the Fed comments, investor appetite for risk has increased. Since the beginning of the year, the spread of investment grade corporate and municipal debt has narrowed versus U.S. Treasury notes of similar maturities. Similarly, the S&P 500 has rallied nearly 7% to 1859, a new record high since closing at 1741 on the first trading day of February 2014. One would assume that the members of the FOMC are watching the heightened risk appetite and factoring it into their thoughts on interest rate policy, which is what prompted the change in discussion at the last meeting.