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Can the Fed Afford Higher Interest Rates?

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Thursday, May 30, 2013

Volatility in the stock market has clearly increased in recent days in response to rising interest rates. The ‘Taper Talk’ since last week has been the primary driver of this shift, with the bond market starting to price in a lower pace of bond purchases by the Federal Reserve in the coming months. In this new framework, all incoming positive economic data gets interpreted by the market as taking us closer to the ‘Taper’ announcement, while weak numbers pushe the announcement date a bit further in the future.
 
This morning’s GDP and weekly Jobless Claims data is modestly on the weak side, which should help keep the market somewhat calmer in today’s trading session. The overnight session out of Japan was anything but calm, with stocks now down more than 14% in less than a week. The trajectory of our stock market in the coming days will depend on how benchmark yields on treasury bonds evolve. And bonds will be looking to economic data to foretell the Fed.
 
The question is whether the Fed will still go ahead with a ‘Taper’ announcement even if the bond market was materially shifting in the wrong direction. I don't think the Fed can afford to let the bond market unwind what they have been able to achieve over the last few years. My sense is that the Fed has some sort of red-lines in terms of bond yields that they wouldn't let the market to cross.

Hard to tell what those bond yield red lines could be at this stage. Given the interest rate sensitivity of the housing market, one can assume that the Fed may not let yields move much beyond the 3% level on the 10-year treasury bond. But there is still plenty of room between where yields are at present and this admittedly assumed yield red line of 3%.
 
The ‘Taper’ framework lets the Fed remain a major player in the bond market even after indicating a change in monetary policy. After all, ‘Taper’ means not an end to bond purchases, but rather a reduction. Meaning that the Fed’s balance sheet will still be growing and they could retain the flexibility to adjust the ‘monthly flow’ up or down. The Fed has been arguing all along that what mattered more was the ‘stock’ of bond holdings on its balance sheet rather the ‘flow’ of monthly purchases. We will see how this ‘stock vs. flow’ debate unfolds in the coming days, but it’s reasonable to assume at this stage that the Fed will not let the bond get out of hand.

A steady and deliberate uptrend in bond yields will be a lot less disruptive for the broader economy. And that’s what the Fed will be shooting for. This does not mean, however, that the adjustment process will be painless for the stock market.
 
Sheraz Mian
Director of Research