Johnson: Don't Fret the Fed

Jeremy Glaser: For Morningstar I'm Jeremy Glaser. After a tumultuous May in the bond market, many investors were closely watching the Fed statement this week. I'm here with Bob Johnson, the director of economic of analysis at Morningstar, to see what the Fed said and what its implications could be for the bond market.

Bob thanks for joining me today.

Bob Johnson: Great to be here.

Glaser: So what exactly did the Fed announce this week? Was there anything out of the ordinary in your mind?

Johnson: You know in the paper statement, nothing really changed from the past releases, and I think that that was pretty much status quo that they will remain supportive of the economy, that they are very closely watching mainly two things: the inflation rate in conjunction with the unemployment rate. And really the tightening wouldn’t begin in earnest until unemployment began to come down, and they reaffirmed that statement.

Now the real point that people might have had point to disagree with probably came out of the press conference, where Fed chairman Ben Bernanke talked about how they might get out of some of their mortgage-backed securities and how that program may end. And when he talked about that program, he said there was kind of decoupling if you will between the mortgage buying and the federal-funds rate. With the Fed-funds rate there was pretty much unanimous agreement that that rate, which is about 0.25% right now, 0-0.25%, will not go up until 2015, and they reaffirmed that in every possible way. I think 13 of the governors were all on board that that was going to happen in 2015. So that was certainly one thing that came across loud and clear.

But on the other hand they did also talk about that they would begin perhaps tapering the purchases of bonds, the mortgage-backed securities in particular, which they have been buying $40 billion-$45 billion worth every month for the last several months. And [they said] that program might slow, and if they stayed on the Fed's relatively optimistic economic forecast, the bond buying might be completely over by the middle of 2014. That would imply that probably the unemployment rate would be about 7%.

Now some people thought that if we had to get all the way down to 6.5% before anything happened with any monetary policy, but that clearly was not what they said. But that’s I think what hit the people real hard in the market Wednesday is that they are talking seriously about tapering and they are talking about even an end of all purchases within less than a year.

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Glaser: So we had been talking about tapering. The market did have that pretty big sell-off on the news. Do you think it was just that the expectations were that it really wasn’t going to happen until maybe the middle of next year?

Johnson: Yeah, I think there was some feeling at the beginning of the week that "Oh, you know maybe those were just trial balloons. This whole tapering thing wasn’t really going to happen. Bernanke will say, 'No, no. We are keeping things easing for a long time.'" I think there were some hopes that maybe that would be what he would say Wednesday or say, "That’s in our long-term evaluation plans," or reaffirm that it's not until 6.5% [unemployment rate] that they start. Something that kind of shored people up a little bit, I don't think people were expecting that they were going to get the complete deal, that if we could stay on a current economic path that maybe we'll be all done with bond buying within a year.

Glaser: Why is there worry about the taper though? You know the Fed's balance sheet will remain extremely large. Bernanke talked about that it's just kind of lifting the foot off the accelerator a little bit, and not hitting the brake. Is there a worry that this is going to cause mortgage rates to rise or going to cause some other interest rates to rise and then hurt the economy?

Johnson: Well, how he obviously characterized it is that their current program to stop buying bonds is really just taking the foot off the gas, not stepping on the brake, if you will. They pretty much said, "We're not selling any bonds anytime in the near future. We may not ever sell them. They may stay on our balance sheet until they fully mature." By keeping them on the balance sheet, that's the thing to look at. And they also said that they would take all the principal, and when people repay their mortgages the Fed would go out and invest that in more mortgages.

Well, if you look at the data, the mortgage market is actually shrinking right now. So if they say that, that's really a pretty powerful statement that it's not going to be a negative effect on the overall markets because if they're doing what they are saying, they're reinvesting what they've got in a market that's naturally shrinking right now. The mortgage market has gone from over $10.5 trillion, probably close to $11 trillion, to something that looks more like just right around $10 trillion. So we shrunk the market. There's more shrinkage in front of us. So I really think that not buying more is not as big a deal as some people make it out to be.

And by the way, they're not the full force in the market that some people think. The Fed owns, right at this moment, about $1.1 trillion of mortgages. And the whole U.S. residential mortgage market is about $10 trillion. So just a little bit over the 10% of the market is what they own today. It isn't like they own all of it.

Glaser: That's a good point. The Fed certainly looms large in a lot of investors' minds. There's a lot of talk about maybe the big rise up in stocks and the support in the housing market is really dependent on the Fed continuing their stimulus and that it's a bit of a house of cards that's going to come tumbling down when the Fed [begins tapering]. What's your view on that? Do you think that these markets can survive the Fed in a different stance?

Johnson: Well, you know, that's why I have a really, really strong and adamant opinion. The Fed has certainly helped nudge things along, just like Cash for Clunkers maybe changed the attitude of the car market [and got it] moving. And then maybe [the market] settled back down on its own a little bit. And then it took off, and we've had a very, very nice auto recovery.

So I really give the Fed a lot of credit for nudging things along. But this idea that they're creating a bubble, that they are just superenergizing the market and that it's the only reason it's gone up--my goodness, there's so many things going right in the U.S. stock market and in the U.S. economy that explain the move in the stock market that it's not all about the Fed.

We've seen tremendous growth in oil and gas reserves and production in this country, which has been a huge factor in the improvement in this economy. The auto industry has gone from building 9 million units at its bottom to back to close to 15.5 million-16 million units. So we've had a huge deal there.

Housing is up. Yes, Bernanke has helped stimulate that. Yes, mortgage rates have stayed low, but there's a lot of pent-up demand. We should be starting 1.5 million new homes every year just to keep up with population. It's pent-up demand. It's not about this artificial stimulus, whether rates are 4% or 5% or 5.5%, it may exclude a few buyers at the edge, but you've got people that just are now having children and need to move in a bigger facility. You've got people that are being born and have to get put somewhere, and that's what's not being captured.

Then you've got productivity. I mentioned the auto industry is practically back to normal. We are practically back at 100% of production in the last recovery. And employment's only about 70% of what it was. We've gone through tremendous productivity enhancement. We've seen corporate earnings go up dramatically. Again that's not all about the Fed. They've helped nudge a few things along, but there are a lot of fundamentals in the economy that are strong, as well.

And I know people may look at the data and say, "The Fed said something. The market is down 200 points. All that's ever moving the market is the Fed." That's the wrong logic behind it. The stock market has come a long ways. We had an upsetting event, and the market reacted to it. You shouldn’t draw the conclusion that the only thing moving the market is the Fed just because when the Fed says something, the market goes down.

Glaser: It can be a bit too much of a focus there. You mentioned that they had pretty rosy economic projections. What happens if the economy doesn't meet that? There is a possibility that they said they could adjust upward or downward, where you could see even more bond buying from the Fed?

Johnson: Yes. If Bernanke has it once, he's said it a million times. But he said, "You know what, if the economy doesn't get better, none of this tapering is going to happen. In fact we could turnaround and start buying bonds again." And he said everything depends on what all the economic metrics come out to be. The Fed forecast underlies all his data, he's really relatively optimistic. They are using 2.3% to 2.8% for GDP growth, inflation-adjusted for 2013.

You all know that I have usually a relatively bullish view of the world, and I'm thinking 2.00% to 2.25% this year. I think if we get to 2.8%, God help us. And if we do, the stock market will be higher because everybody's corporate earnings will be dramatically higher.

Then for next year, the [Fed's forecast is] really at 3.0%-3.5%, which seems like even more of a stretch to me. I think something more like 2.5% looks like kind of a top number for next year to me. So I think the Fed's forecasts have been too optimistic before. They got called on the carpet at the press conference a little bit for that Wednesday, and I think they are too optimistic again. And maybe none of these tapering programs ever really happen because the economic data just isn't there to support it. I tend to be a little bit more cautious. I think we had a nice growth rate in the first quarter, but we'll certainly be under 2% in the second quarter.

Glaser: How about inflation? It's running very low. Too low for even one of the Fed governors, do you think that that could become a problem of deflation kind of rearing its head again here?

Johnson: Bernanke did allude to it; they don't want to see inflation get too low. But he seemed to feel that some of the low inflation rate was due to kind of some odd things in the oil industry, and that perhaps some of the medical payments issues were kind of weighing on the inflation number a little bit. Then certainly just on the natural course of things, they'd be going a little higher. So he was not worried about inflation. Nevertheless, the Fed did drastically cut its inflation forecast for this year and next.

Glaser: So another topic of conversation at the press conference and beforehand was, is this Bernanke's last term? Is his tenure at the Fed ending? President Obama made some comments that seemed to indicate that Bernanke is on the way out. Looking at the potential candidates that could come in, the potential makeup of the Fed, would you expect for there to be any major policy changes after the Bernanke era ends?

Johnson: It seemed like the president was pretty darn clear that this was probably the end of the line for Bernanke in the interview. So I think the premise is that he's gone, I'm surprised the market hasn’t even reacted a little bit more strongly to that than it has. But I think he is done. I think that there are a lot of very capable people on the Fed. Every time we talk, we talk about how there is vote and there are a number of people on the Fed voting committees. And it's not all about one person. It's a job sometimes of persuasion to get everybody all in line, but it really is a very well-established group with a lot of people, a lot of different personalities. And I think a number of people could really do a nice job in that position.

I think that there is nobody that's rolling back, there's nobody that says, "If I ever get a hold of this, I'd rule out QE." And certainly that's not going to be somebody who is likely to be appointed by President Obama anyway. So, I'm really not expecting to get a new hawk in there to run the Fed. I don't think that's a very likely thing at all, and I think that somebody who remains relatively loose with their policies is possible.

Glaser: Bob, finally, you said that there isn't a big chance of interest rates really rising at least with the Fed raising its key rate until 2015. What do you think that means for kind of the bond market, for the Treasury market? We saw yields tick up pretty significantly during the last couple of months? Would you consider that to keep happening?

Johnson: Well, let's talk about. Let's take just one number there, and the number I mentioned is the real short-term rate that helps to control bank lending and so forth, the so-called Fed-funds rate. That's the one number they always have control over, and later with their bond-buying programs they control of few other markets, as well. The 10-year Treasury rate is a good benchmark, and it usually runs 2.0%- 2.5% above whatever the underlying inflation rate has been for the last year, and it's not a lot more complex than that, if the Fed's not intervening in the market. We got the rate down as low as 1.4% when the Fed was really in full gear, and right now rates have come back up dramatically in the last few weeks, and we're kind of in the 2.2%-2.3% range. So, we have come not quite a full point, but close to it, and we may have just about that much left to go. And my basis for that as we got the inflation index running around 1.1% at least on the Fed's preferred measure, and you take that 1.1% and you add 2.0%- 2.5% to it and you are somewhere in the 3.0%- 3.5% range. So, that's where Treasuries will go. If you can't endure a 3%- 3.5% Treasury bond rate, you probably got an issue.

Rates will go there. We just don't know if it will be tomorrow or if it's going to be a year from tomorrow. But that's were rates have to be and where they go, and that's kind of the minimum expectation of where they have to be. It's been interesting through the Fed gossip mill and leaking speeches and so forth and disagreeing governors. I thought we'd have a day where they said, "Well, we're not doing a more bond buying, and it's in our press thing," and that the rates would go up to 3% immediately within two or three days.

Instead here with all the disagreements, "It depends on this and depends on that," it looks like we've manage to sidestep the one-day 2% move, and we've kind of eased into a just a little bit.

Glaser: Bob, thanks so much for your analysis today.

Johnson: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser.