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Fed Sheds Light on Exit Strategy and Rates 

Kristina Hooper 



The markets are reacting negatively to the latest Fed news and its implications for QE tapering and rate hikes. Kristina Hooper interprets what's happening behind the scenes and what it means for investors.
Global markets have been reacting strongly to the June 19 news from the US Federal Reserve and Chairman Ben Bernanke. The Fed is upbeat on the US economy but is so far holding off on decisions to unwind its monthly bond-buying program known as quantitative easing (QE). The Fed also expects to maintain short-term rates at current levels, but anticipates that potential hikes may occur earlier in 2015 than expected.

As such, we anticipate that both equity and bond markets will experience continued volatility as each economic data point receives a high level of scrutiny from the Fed for its potential impact on QE. When the numbers disappoint, markets may react positively because it may mean prolonged easy money—a trend that has already begun playing out after recent economic releases.

Our Interpretation of the Fed's News

The hawks are winning

Both the FOMC minutes and a subsequent press conference by Fed Chairman Ben Bernanke were more hawkish (i.e., anti-easy money) than expected, which triggered the negative reaction by bond and equity markets.

The Fed may be too optimistic
Fed projections are now more optimistic than consensus or our growth estimates, although the Fed generally has an optimistic bias. For example, reaching the Fed's mid-range growth estimate for 2013 would require Q3 and Q4 numbers beyond Q1's already healthy 2.4% annualized growth rate. And while the Fed's unemployment rate projections are reachable, they assume no meaningful pickup in the labor participation rate.

An end in sight for QE
The market is finally getting more clarity on QE tapering, but the Fed's decisions about when to actually begin pulling back will be very dependent on employment and inflation data.

Rate hikes: Sooner but not sudden
Expectations for when a Fed funds rate hike may finally occur may be moved up by consensus. Bernanke nevertheless has made clear that the 6.5% unemployment rate is only a “threshold”—not an automatic “trigger”—for rate hikes.

What It Means for the Markets

Stocks over bonds

Assuming a moderately constructive macro scenario, we prefer equities over fixed income. Equities can compensate for less QE against a solid backdrop of improving earnings outlook, an improving developed markets economy and still-low inflation. At the same time, a better economy and less QE are negative for bond markets.

Developed over EM equities
Within equities, it confirms our preference for developed markets versus emerging-market equities, which we favor because of a stronger US dollar, higher US real interest rates and a decreasing growth delta between developed markets and emerging markets. This is also confirmed by ongoing disappointments in EM macro data, such as the worse-than-expected Chinese purchasing managers' data announcement of June 20.

Cyclical over defensive
Within equity sectors, expect a temporary tailwind for cyclical sectors (including financials), while rising rates and steeper yield curves point to a pause for growth stocks and more defensive, higher-yielding stocks.

Yields may not rise much more
For sovereign bond markets, the rise in yields may only continue for a while longer. Assuming short-term rates do not increase massively, much more steepening appears improbable at this point.

The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

A Word About Risk: Investing involves risk and you can lose money. Equities have tended to be volatile and, unlike bonds, do not offer a fixed rate of return. Bond prices will normally decline as interest rates rise.

Allianz Global Investors Distributors LLC, 1633 Broadway, New York NY, 10019-7585,, 1-800-926-4456.


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