As 2012 came to a conclusion, Congress continued to bicker over the details of the fiscal cliff settlement. With across-the-board tax hikes and spending cuts looming and the Republican Party weakened by Speaker of the House Boehner’s failed “plan B” bluff, a compromise was reached on the last day of the year. As it stands, taxes will rise on families making more than $450,000 while no real concessions were made on spending or the debt ceiling. With only a partial solution, citizens can expect another round of political mud-slinging and personal attacks as the terms of the debt ceiling are debated prior to the deadline which is expected to be reached in March. Recall that during the summer of 2011, the debate became so contentious that the threat of a missed coupon payment prompted Standard & Poor’s to downgrade U.S. Treasury debt to “AA”. With the specter of such an outcome weighing on the minds of investors, bond prices were volatile during December, experiencing selling pressure for most of the month.
While Congressional bickering and backbiting raged on the Hill, the Federal Reserve continued to confound investors with their policy of communication transparency. During his press conference at the conclusion of the December FOMC meeting, Chairman Bernanke announced that the Federal Reserve had adopted economic targets as guideposts for monetary policy. He explained that the Fed is now pledging to extend quantitative easing until the unemployment rate has fallen to 6.5%. Ironically, the change in policy is actually a change back to the manner in which monetary policy was conducted before Bernanke took the helm. The change was widely expected, but the “whisper” unemployment trigger was a bit higher at 6.7%. Traders interpreted the lower target rate as a signal that the committee had grown more worried about the state of the economy. Consensus quickly developed that quantitative easing would be in place at least into 2014 and perhaps into 2015. With that, investors were stunned when the January 3rd release of the minutes of that meeting painted a very different picture. Specifically, the committee was far from unanimous in its thinking, as it was noted that several members expected to end quantitative easing in 2013 and all but one member was in favor of establishing an economic threshold to raise interest rates. That communication is far different than what Bernanke portrayed in the post-meeting press conference. The market reaction was swift and decisive. Deducing that the Fed would not be an unlimited buyer of Treasury notes and that the committee was already considering rate hike options, investors dumped bonds. That reaction is sensible. If the Fed ceases holding interest rates at artificially low levels, there is no economic rationale for holding Treasury notes that yield less than the rate of inflation. To do so would be to intentionally reduce the future purchasing power of the investment. Also factoring into the selling was the understanding that if the Fed decides to raise rates, they will become a net seller of Treasury securities. The mechanism for raising rates is for the Open Market desk at the Federal Reserve to sell short-term Treasury securities to member Banks in an amount that will more than satisfy the banks need for investment. While it’s highly unlikely the Fed will raise rates any time soon, the message from the minutes is that the process of going from highly accommodative to neutral monetary policy has begun.