The Federal Reserve is close to ending its massive bond buying program. The next step is to normalize interest rates. But what is normal?
The Fed is steadily marching toward the conclusion of its much-vaunted purchases of United States Treasuries and mortgage-backed securities. The program has been widely applauded by Wall Street, where many of the major market averages have hit new highs this year. As for the economy, it has been nurtured back to health from the depths of an unusually steep recession from 2007-2009 by low financing costs supported by the central bank’s zero interest rate policy and its aggressive bond buying.
At its July Federal Open Market Committee (FOMC) meeting, the Fed, as expected, reduced its monthly securities purchases by $10 billion, to $25 billion. The makeup of the buying spree now consists of $15 billion of U.S. Treasuries and $10 billion of mortgage backed securities. After the scheduled September FOMC meeting, the Fed will presumably be down to $15 billion a month in asset purchases, and the program is set to end in October.
The next shift in Federal Reserve policy will come when the lead bank begins raising interest rates. Currently, the thinking is that the short-term interest rates the central bank influences through its targeted federal funds rate will start rising by the middle of 2015. Of course, nothing is set in stone, and the Fed will only hike rates if it deems the situation calls for that course of action. That precludes any unexpected economic deterioration stateside or international event that might cause disruption in the financial markets. Fed Chair Janet Yellen took great care in her comments not to diverge from that philosophy at a recent conference in Jackson Hole, Wyoming.
Many observers are anxious to see interest rates return to a semblance of normalcy. But what does that mean? The so-called yield curve has maintained a normal pattern for a number of years now, with long-term interest rates higher than those on the short end of the curve. But with short-term interest rates effectively at zero, it is clear that rates are dramatically skewed toward the low side. Only when short-term rates move up to the 1%-2% range and long-term rates rise in conjunction will it likely seem that interest rates have normalized.
But it is far from assured that the Fed will raise rates through a steady progression of hikes within a fairly short term of around six months to a year, as was the case during past monetary tightenings. There is a chance that the next series of rate hikes could have longer-than-usual periods in between each progressive move higher. Once again, the economic data will be the deciding factor.
So far, the Fed has had the leeway to take a dovish stance on monetary policy, given the lack of reported inflation and slack in the labor force. But the unemployment rate has fallen to 6.2% from 7.3% in the past year, suggesting labor market conditions are tightening. Moreover, government-reported inflation readings don’t always portray pressures building in the economy. A clear example of that risk is last decade’s subprime mortgage sector meltdown that spread into the broader economy.
At the end of the day, it appears that the massive stimulus provided by the Federal Reserve through its bond-buying activity and zero-interest-rate policy will be history within the next 12 months. Investors looking to position their portfolios in advance for that shift may wish to look more closely at the shares of banks and insurance companies, many of which would benefit from higher interest rates on fresh assets or variable-rate assets. Shares of PNC Financial (PNC) and Metlife (MET) are a couple of examples.