Janet Yellen was sworn in as Federal Reserve chair Feb. 3, 2014, ending Ben Bernanke’s eight-year tenure. Yellen assumed her role at a time when the economy was its strongest since the recession ended in mid-2009. This put her in a position where she could taper down the fiscal measures the Fed had to take when it was in recession emergency mode; she will be using a process that is, appropriately enough, known as "tapering."
First, a bit of context. Yellen embarked on her term with two main goals. The first: to reduce the unemployment rate to 6.5% or lower and strengthen labor-market conditions so that wages and jobs increase. The jobless rate in January was 6.6%; wages are stagnant and job growth is still slow. Her second goal: to increase inflation to 2% (currently at 1.6%) and avoid deflation.
To accomplish these goals, Yellen said she intended to keep the Fed funds rate target around 0%, where it has been since 2008. A low Fed funds rate means low interest rates, which are good for borrowers but bad for savers. She also planned to continue the Fed’s purchases of agency mortgage-backed securities and longer-term Treasury securities, a program known as quantitative easing, which began under Bernanke in 2008 in an attempt to improve the economy. The Fed is currently in round three of this program (dubbed QE3), but as of last December, it started decreasing asset purchases from $85 billion per month to $75 billion and then $65 billion. This is where tapering comes in - the term refers to this gradual decrease.
On Feb. 11, Yellen gave her first public comments as chair in her semiannual report on monetary policy and the U.S. economic outlook. She pledged to continue Bernanke’s work to strengthen the economy and the financial system and said, “I am committed to achieving both parts of our dual mandate: helping the economy return to full employment, and returning inflation to 2% while ensuring that it does not run persistently above or below that level.”
Yellen expected moderate improvements in economic growth and unemployment for 2014. She said, “I expect a great deal of continuity in the FOMC's (Federal Open Market Committee) approach to monetary policy. I served on the committee as we formulated our current policy strategy and I strongly support that strategy.” She said that just because unemployment and inflation figures meet the Fed’s targets, this does not mean the Fed funds rate will automatically increase. The stock market responded favorably to her comments, with the Dow increasing 1.2% and the S&P 500 up 1.1% from the previous day, reversing the market’s recent losses. Given current economic conditions and Yellen’s comments, here is what we can expect to happen with Treasury yields and tapering QE3 in the short to medium term.
Treasury Yields: Why We Should Expect More of the Same with Yellen
The Treasury yield is how much investors earn by buying and holding debt securities - bonds, notes and bills - issued by the U.S. federal government’s treasury. It is important to individuals and businesses who want to borrow money because when yields are low, interest rates on loans for mortgages, cars and business loans are low. It is important to investors because the lower the yield, the less they earn from safe investments in Treasuries and the more likely they are to seek riskier investments, such as stocks, to earn a better return. Also, the higher long-term (10- to 30-year) yields are, the more optimistic investors feel about the economy’s long-term performance. Treasury yields have been very low since 2009. As of Feb. 18, one-year Treasuries yielded 0.12%, 10-year Treasuries yielded 2.71% and 30-year Treasuries yielded 3.68%.
We can expect yields to remain low for several reasons.
While Yellen is new to the role of chair, she is not new to the Fed. In fact, she has been heavily involved in the Fed since 1994, when she joined its Board of Governors, a seven-member group that helps vote on Fed policy. As the Fed’s vice chair from 2010 through 2013, she was second in command under Bernanke.
Yellen has openly praised Bernanke and shares many of his views. She has said she believes what the Fed has done since the financial crisis, including quantitative easing, has been working. She says she plans to continue with the same policies at least until inflation reaches 2% and unemployment decreases to 6.5%. With the overall labor market still weak, even if unemployment hits 6.5% soon, Yellen does not want the Fed to change tactics until these other measures improve as well. The falling unemployment rate may be less positive than it appears, as many workers have simply left the workforce to go back to school, to retire, or because they have given up on the job search. Millions of workers are also underemployed. Given these factors, a more accurate unemployment rate might be around 13%.
Yellen is considered a dove, meaning she promotes monetary policies that keep interest rates low. She is also a strong proponent of forward guidance - clear communication with the public about what the Fed intends to do in the future and under what circumstances. So there shouldn’t be any surprises in Fed policy that could shock the markets, except insofar as the Fed cannot predict what the economy will do. The Fed might take an unexpected course if the recovery doesn’t continue as anticipated. The Fed’s most recent forward guidance, provided after its Jan. 30 meeting, is to continue with its current policies.
With Yellen in charge, “Treasury yields will continue to stay low,” said Sumant Gupta, head of corporate development at iTB Holdings, which provides fixed-income electronic trading solutions to institutional investors. Gupta has over 14 years of experience trading fixed-income securities on Wall Street. “The economy has benefited from the low-yield environment. However, there are still over 10 million unemployed Americans,” he said. “Economic growth is moderate at best and inflation is not a concern. For these reasons, the Federal Reserve under Janet Yellen’s leadership will continue to keep yields low to promote economic recovery.”
If GDP grows faster than the 3% or so Yellen is predicting for 2014, however, bond yields could increase as investors anticipate the Fed increasing interest rates to prevent the economy from overheating.
Yellen and Tapering
“Tapering” is the gradual winding down of QE3 through decreasing the U.S. Treasury’s monthly purchases of agency mortgage-backed securities and longer-term Treasury securities. This program began in 2008 in an attempt to bolster the economy, and since economic conditions have improved, the Fed is working toward winding the program down. It has gone from purchasing $85 billion in assets per month to $75 billion to $65 billion and plans to continue this gradual reduction until it is no longer purchasing any assets. Quantitative easing was implemented as an extreme measure to rescue a floundering economy; it is not part of the Fed’s usual activities.
In her Feb. 11 testimony, Yellen said the Federal Open Market Committee (FOMC) would likely continue tapering if labor market conditions and inflation continue to improve. But she emphasized that “purchases are not on a preset course,” but depend on the “outlook for the labor market and inflation” and the Fed’s “assessment of the likely efficacy and costs of such purchases.”
If tapering continues, Treasury yields could increase. Bernanke’s mere announcement of tapering last year caused yields to rise, which meant higher interest rates for borrowers and savers.
“I expect Treasury yields to continue to rise in a Yellen-led Federal Reserve” in the short to medium term, said Evan A. Schnidman, founder and CEO of Fed Playbook, a financial forecasting and analysis firm that uses quantitative data to forecast Fed policy and market outcomes. He said that while Yellen has a dovish reputation, “The voting members of the FOMC in 2014 are more hawkish than any group in the last few years, and the strength of any Fed chair is consensus building, not dictatorial power. So, I expect that Chairwoman Yellen will follow a consensus path of continued tapering with modest adjustments to forward guidance to account for new employment figures. Market actors will continue to perceive this as tightening, and thus rates will continue to rise for at least the first half of 2014,” Schnidman said.
Yellen has said that she wants the Fed to revert to traditional monetary policy (meaning no more quantitative easing) once the economy returns to normal, but no one knows when that will be. It needs to end the program carefully to prevent unintended consequences, such as overstimulating the economy, which could cause undesirable inflation levels.
“Chairwoman Yellen and therefore Fed tapering can be expected to follow a consistent, transparent path,” said Jonathan Citrin, founder and executive chairman of Birmingham, Mich.-based CitrinGroup, an investment advisory firm specializing in portfolio management for high-net-worth individuals, institutions, businesses, trusts and non-profits worldwide. “Yellen should carry on the Bernanke tradition for undisguised policy, leaving investors only to question how a continued adherence to the taper will impact bond yields.
“Traditionally, which is to say academically, as the Federal Reserve reduces the size of its monthly bond purchases, the demand for Treasury bonds will diminish and force yields higher,” Citrin added. “We have seen this trend since even before the actual taper commenced - markets last May reacting strongly to the simple announcement of a forthcoming taper, despite the fact it was almost seven months between the announcement and any actual action seen in December.”
Right now, experts see tapering following a steady, predictable path.
“The Fed is going to taper gradually over time if economic growth continues at the current pace,” Gupta said. “During this period, long-term Treasury yields are likely to slowly move higher but still remain low by historical standards. If the economy stalls, the Fed can stop or even reverse tapering, in which case long-term Treasury yields will go down again. Short-term Treasury yields will continue to be low despite tapering until the Fed raises interest rates, which is unlikely in the current scenario.”
The Bottom Line
With Yellen as Fed chair, we can expect more of the same without the uncertainty of “What will happen when Bernanke leaves?” Keep in mind that while the Federal Reserve can influence the economy, it can’t control it completely, as the recent faster-than-anticipated drop in the unemployment rate illustrates. Last year, the Fed thought we wouldn’t see 6.5% unemployment until at least 2015, but we’re almost there. While the markets are unlikely to be surprised by Yellen’s actions if the economy continues to follow its current trajectory, unanticipated events could cause the Fed to change course and cause yields to drop or to increase faster than anticipated. Stay tuned to see what happens in the next FOMC meeting, which will be Yellen’s first as chair, March 18–19.