Wealth Management Research

26 January 2012

Global financial markets

The Fed shows its hands
The Federal Open Market Committee (FOMC) surprised markets
by stating it expected to maintain the exceptionally low federal funds rate "at least through late 2014," a change from its previous statement of "at least through mid-2013." It also edged one step closer to another round of quantitative easing (QE3).
Thomas Berner, CFA, economist, UBS FS thomas.berner@ubs.com Jeremy Zirin, CFA, strategist, UBS FS jeremy.zirin@ubs.com Anne Briglia, CFA, strategist, UBS FS anne.briglia@ubs.com

The release of the FOMC participants' views on the timing of the

first rate hike and their projections of the fed funds rate were aligned with the FOMC statement, providing little new insight. The FOMC also decided to introduce an explicit inflation target and lowered its real GDP growth forecasts.

On equity markets the "lower for longer" interest rate policy will
likely benefit dividend paying stocks and gold mining stocks, while hurting banks' net interest margins.

Fig. 1: Fed funds futures price in less aggressive rate hikes in 2014 Implied average fed funds rate per month in % (as of 24 Jan 2012 and 25 Jan 2012)
1.00 0.80 0.60 0.40 0.20 0.00 Jan-12 Jul-12 25-Jan-12

On bond markets the new policy will likely hurt money market funds
as they will scramble to generate returns, but will likely spur carry trades with the US dollar as funding currency. The Fed eases again The Federal Open Market Committee (FOMC) surprised markets by easing monetary conditions using its statement. It now "anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014." In the previous statement from December the anticipation was to keep the fed funds rate exceptionally low until "at least through mid-2013". The FOMC also added the sentence that the "Committee expects to maintain a highly accommodative stance for monetary policy". With these language changes the FOMC has effectively led markets to price out more aggressive rate hikes in the distant future. Before the release fed funds futures market was expecting a first rate hike in early 2014. Now the market adjusted to reflect the FOMC's new language and now signals first rate hike expectations in mid-2014 (see figure 1). Since longer dated Treasury yields reflect future expected short-term yields, the 10-year Treasury yield fell by 14 basis points to 1.91% after the announcement. However, the yield rebounded to around 2% at the end of the stock market trading session.

Jan-13 Jul-13 24-Jan-12

Jan-14

Jul-14

Source: Bloomberg, UBS WMR; as of 25 January 2012

This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures that begin on page 6. Past performance is no indication of future performance. The market prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts and tables in this publication.

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If needed, the next policy step will likely be QE3 The FOMC tweaked the language pertaining to future policy action. In the December statement it alluded to several tools it could use to promote growth: "The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools to promote a stronger economic recovery in a context of price stability." In today's statement it narrows its tool set down to one: "The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in a context of price stability." The Fed can use its balance sheet in two ways to ease monetary conditions. It can change the composition of its securities holdings. This was what the Fed did when it started Operation Twist in September 2011. Through sales of shorter dated Treasuries and purchases of longer dated Treasuries with the proceeds it aims to lower the longer dated yields which are more important for borrowers than the shorter dated rates. Note that Operation Twist does not change the size of the Fed's balance sheet. Alternatively, the Fed can grow its balance sheet by buying securities such as Treasuries or agency mortgage backed securities (MBS), so-called quantitative easing. Such action is more expansive than just changing the composition of the Fed's holdings since it increases the overall amount of bank reserves and thus liquidity in the system. In its statement the FOMC keeps both of these policy options open as the next possible step. In our view, if further stimulus is needed it would likely be more quantitative easing (QE3) rather than another Operation Twist. We think, however, that the Fed will likely only embark on QE3 if growth is weak enough to change the medium term core inflation outlook from sideways to down. An historic event with little new information For the first time in the history of the Fed the FOMC published its participants' views on the likely year of the first rate hike as well as their forecasts of the fed funds rate (see figures 2 and 3). The new information seems consistent with the language of the statement. The year 2014 gets the highest count of FOMC participants as the likely year in which the first fed funds rate hike might occur. Furthermore, the forecasts of the level of the fed funds rate per year also show that the median forecast - the forecast that divides the observations in equal numbers on each side - envisages a rate hike in 2014 and not earlier. The level of the median forecast in 2014 is 0.75%. Finally, the median estimate of the FOMC participants' views on the level of the fed funds rate in the longer run is 4.25%. Eying the updated Summary of Economic Projections (SEP) (see figure 4) this seems consistent with about 2.3-2.6% real GDP growth and 2% inflation in the longer run, as in equilibrium the short-term interest rate level tends to reflect nominal GDP growth. So the new information doesn't seem to add an awful lot of new insight relative to the statement and the SEP, although it increases the transparency of the FOMC participants' expectations. The additional insight is more nuanced. We now know that six out of seventeen FOMC participants (see figure 2) expect a first rate hike after 2014. We don't know who they are, but it does tell us that overall the FOMC seems more worried about weak growth and disinflation than without this new information. Before the only way to infer whether some FOMC members were against the consensus vote was if they dissented. We know that last year three participants dissented to more easing in August and September - a hawkish dissent, but we only had indication of one (dovish) dissent (Federal Reserve of Chicago President Charles Evans) to the lack of additional stimulus in November. Therefore, the new information is valuable in that it shows that more than a third of all participants expect rate hikes starting later than in 2014.

Fig. 2: Most anticipated year for first rate hike is 2014 Histogram of timing of first Fed rate hike

Source: Federal Reserve, as of 25 January 2012

Fig. 3: FOMC participants see fed funds rate at 1% by year-end 2014 Distribution of FOMC participants' views on the level of the fed funds rate per year-end and in the longer run, in %

Source: Federal Reserve, as of 25 January 2012

Wealth Management Research 26 January 2012

Global financial markets

Fig. 4: The FOMC lowers its real GDP growth forecasts Forecasts for real GDP growth and inflation (on a 4Q-over-4Q basis, in %) and the unemployment rate (per year-end, in %)

Source: Federal Reserve, as of 25 January 2012

The FOMC gets explicit The FOMC also decided today to give an explicit inflation target that it wants to pursue in the longer run. The target is set at 2% year-over-year change in the price index for personal consumption - also called personal consumption expenditures deflator or PCE deflator. With this change the FOMC makes explicit and implicit target that it was already publishing as part of its SEP. In the last update of the SEP in November 2011 the longer run projection of PCE inflation was 1.7-2.0%. Since the Fed is mandated by Congress to achieve not only price stability but also full employment, it will continue to balance its policy to achieve both. However, the FOMC refrained from stating and explicit longer run unemployment rate target since it argued that this target can change over time. So it chose to stick to its current template of providing longer run projections for the unemployment rate, which were pegged at a central tendency of 5-6% today - the central tendency eliminates the three highest and lowest projections of the 17 FOMC participants. The explicit inflation target may bind the Fed's hands a bit more than the informal or implicit longer run projections of inflation. However, we doubt that this constraint is huge, since the Fed still has to oblige to its dual mandate price stability AND full employment. The main aim of the push toward an explicit inflation target is to better communicate with the public that this is the Fed's long-term goal as opposed to a changing longer run inflation projection. This should help anchor inflation expectations at close to 2% as long as the Fed retains its credibility. The Fed's growth outlook deteriorates In the updated SEP the FOMC now expects central tendency of real GDP growth of 2.2-2.7% in 2012. In November the central tendency was 2.5-2.9%. We currently forecast real GDP growth of 2.1% in 2012. So, in our view, the FOMC still seems too optimistic. Given that the FOMC also signaled that the next policy step might be QE3, we assess that if our forecast materializes that the FOMC would be disappointed and might be more inclined to embark on QE3. For now we still think that such a move can be avoided, since weaker than expected growth would have to be acWealth Management Research 26 January 2012 3

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companied by a change in the medium term core inflation outlook from stable to down. At present neither we nor the Fed expect that. So today's FOMC announcement is merely one step closer to QE3, without making it a foregone conclusion. Equity markets: "Lower for longer" winners and losers What does an extension of the expectation for lower short-term interest rates mean for equity markets? At a market level, probably not much over the intermediate (6-12 month) term. While equity markets have initially rallied following the latest sugar rush from the Fed, further extending zero percent short-term interest rates by an additional 1.0-1.5 years also extends the period of financial repression for savers. This incremental policy step toward further monetary (read: quantitative) easing suggests that the Fed remains very concerned about the sustainability of the recent better-than-expected US economic data as well as the supposed reduction in systemic risks in Europe following more aggressive action by the ECB. As we recently discussed in The Decade Ahead - The Great Develeraging report, both below-average economic growth and above-average economic volatility weigh on equity market valuations. We doubt that elevated equity risk premiums will sustainably decline when monetary policy steps move further away from "normal". Within the equity market, "lower for longer" interest rates should be a clear positive for dividend paying stocks since their relative yield advantage over fixed income alternatives is extended. The relative earnings stability of dividend payers over non-dividend payers should also be rewarded in an environment with greater economic uncertainty. This, at least in part, justifies the current high relative valuations of the Utilities, Telecom and Consumer Staples sectors and Real estate investment trusts (REITs). Gold mining stocks should also benefit as gold prices are supported by an even longer period of negative real short-term interest rates. Conversely, low interest rates will likely be a headwind for Financials. Banks will face continued pressure on net interest margins while loan growth is capped by ongoing consumer deleveraging while life insurers and trust banks will face lower reinvestment rates of return. Bond markets: Lower for (much) longer For investors in money market funds or in cash equivalents, the Fed's decision to stay lower for longer increases the likelihood of negligible returns for the next two or three years. We anticipate that assets held in money market funds will continue to fall, as investors shift holdings into other asset classes with higher total return potential. In addition, the Feds signal that it intends to run an extremely accommodative monetary policy for much longer is the "all clear signal" for investors involved in carry trades. The Fed's decision should benefit institutional investors, such as REITs, that borrow short term and invest in longer-term assets, and this could lead to a further flattening of the yield curve inside of the 10-year maturity area. The long end of the Treasury curve is likely to lag, however, because we believe the odds of a policy mistake have increased - and by this we mean a policy mistake not only by the Fed, but also by investors as well if they give too much credence to the Fed's guidance that later turns out to be wrong. The potential for the Fed to stay too accommodative for too long could limit the downward pressure on yields at the long end of the curve on investor concerns about the long term inflation implications. Finally, bear in mind that the Feds future actions will continue to be dictated by the economic data. If the current communication policy gives investors a false sense of comfort about the timing of future Fed decisions, the fixed income market could experience more, not less volatility going forward, when some investors will find they overplayed their hand.
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Wealth Management Research 26 January 2012

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Wealth Management Research 26 January 2012