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Warming Up to the Fed Taper 

Kristina Hooper 

The Upshot 

7/8/2013 

Kristina Hooper, US head of investment and client strategies, highlights a shift in investor sentiment on a potential unwinding of QE measures, and what it means for housing and the broader economic recovery.
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Kristina Hooper, CFP, CAIA, CIMA, ChFC, is US head of investment and client strategies for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.

Investors may be getting more comfortable with Fed tapering, as employment and consumer sentiment continue to show signs of improvement.

The much-awaited June employment report came out on Friday and investors reacted positively, bidding up stocks. The report showed that non-farm payrolls in June significantly exceeded expectations. The rally came as a surprise since bad news has been good news lately, especially when it comes to jobs. Indeed, stocks have sold off recently whenever there's been positive economic data because investors feared an end to the Fed's QE program.

So why the change in sentiment among investors? It could be that they're finally coming to terms with the idea that tapering will occur, in part, because they're more confident that the pace of the recovery is quickening. And that the economy may soon be healthy enough to grow without using the Fed as a crutch.

While investors bought stocks, they sold bonds, pushing the yield on the 10-year Treasury above 2.7%. But it's not just bonds that have been unpopular with investors: according to the Investment Company Institute, bond funds had $28.1 billion in net redemptions in the week ended June 26, which is the biggest withdrawal since ICI began tracking weekly numbers in January 2007. Investors seem to be coming to the realization that core fixed income is vulnerable in an environment where rates rise even slightly. But the run-up in stocks indicates investors are also confident that the economy is on the mend. Perhaps investors believe we're returning to a more normalized economic climate, one that doesn't rely on the Fed.

Buying Spree?

One area of the economy that best reflects this mood swing is the consumer. According to last week's Bloomberg Consumer Comfort Index, a survey of Americans' ratings of the national economy, the buying climate and their personal finances, consumer sentiment closed at its highest level since January 2008. It was also the best quarter for consumer sentiment since the fourth quarter of 2007. Interestingly, the most encouraging component was personal finances. This makes sense given that consumer balance sheets are generally in better shape. The household debt service ratio is at an all-time low. (The Fed began tracking this measure in 1980.) The financial obligations ratio is also close to an all-time low, which arguably shows an even more accurate picture of the lighter burden consumers are now enjoying.

But there are, of course, threats to this consumer recovery. Most notable is the rise in mortgage rates. There is growing fear that higher rates will derail not just the housing recovery, as evidenced by the sell-off in homebuilding stocks on Friday, but also the consumer recovery. Friday was a momentous day in mortgage rate history that could fuel this fear. Mortgage News Daily reported that conventional 30-year mortgage rates moved powerfully into the 4.75% range, with some lenders quoting 4.875%—a huge jump from just Wednesday. The publication reported, "Today's rise in mortgage rates is among the largest ever, and certainly the largest in the past 10 years. Today alone, rates rose more than most entire weeks."

So far, the rise in rates has mostly impacted refinancings, not new purchases. For example, the MBA Purchase Applications Composite Index was down 11.7% for the week ended June 28. But while the refinance index was down 16%, the purchase Index was down just 3%. It remains to be seen what Friday's dramatic rise in rates, especially if it moves even higher, will do to overall mortgage applications.

Mortgage Rates are Heating Up

What's Next?

In terms of where mortgage rates go from here, there are many possibilities. We could see employment weakness in future reports, which might postpone tapering and likely push mortgage rates lower. However, it's unlikely that employment will weaken given the strength we've seen in June payrolls and the revisions to April and May numbers. In fact, it suggests that the Fed is correct to guide the market towards tapering, which may occur as soon as September. Or we could see the Fed taper the $45 billion per month in government bond purchases but not the $40 billion in purchases of mortgage-backed securities, which could drive mortgage rates lower from here.

Even if tapering occurs and includes mortgage-backed securities, both scenarios should be good news for investors—at least in the long run. We could see the Fed taper asset purchases and mortgage rates climb to the 5% region. But because the economic recovery is robust enough, the housing recovery may continue based on organic demand, especially if housing affordability remains attractive. With home values higher, more people with mortgages in the 6% to 8% range will be eligible for refinancings, homeowners who had previously been "underwater" in their mortgages; refinancing even in the low 5% range will give them more spending money and could boost the economy.

Alternatively, we could see tapering occur, mortgage rates climb into the 5% region and the economic recovery slow. Even in that worst-case scenario, it's likely the Fed would pull back on tapering. It's important for investors to recognize that, in many ways, financial repression is a dial that can be moved up and down.

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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.

 
Past performance of the markets is no guarantee of future results. This is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities.


A Word About Risk
: Equities have tended to be volatile, involve risk to principal and, unlike bonds, do not offer a fixed rate of return. Foreign markets may be more volatile, less liquid, less transparent and subject to less oversight, and values may fluctuate with currency exchange rates; these risks may be greater in emerging markets.
 
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Allianz Global Investors Distributors LLC, 1633 Broadway, New York NY, 10019-7585, us.allianzgi.com, 1-800-926-4456.

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