Recent data from the Treasury Department shows that China bought more US Treasury debt in October than any other foreign country. The increase of $10.7 billion was comprised mostly of short-term Treasury bills, which shows that China is very alert to the looming interest rate risk. The price of short-term bonds does not swing as wildly as those of long-term bonds when market interest rates change.
Dow Theory Letters has recommended low exposure to bonds during this period of rising rates, and continues to maintain that recommendation. If you are invested in bonds, we would suggest you follow the Chinese, and focus on short-term instruments.
Based on data from CRT Capital Group, China's Treasury holdings as of October were at the second highest level ever. The October holdings of 1.3045 trillion are second only to holdings of $1.3149 trillion in July 2011. It should be comforting that foreign investors are still demanding US Treasuries, especially after the government shutdown in October, and with the Fed set to reduce its bond purchases.
Some on Wall Street are discussing an idea known as "The Fed Put."
For those who aren't familiar with options, the reference to a "put" can be likened to there being a floor under the market. The buyer of a put option has the right, but not the obligation, to sell shares of a particular asset at a certain price, in the future. Many investors buy puts as a form of insurance when they think market declines are imminent.
The concept of a Fed Put has to do with the idea that a tapering now does not mean the withdrawal of stimulus will continue unabated. The Fed has repeatedly stated that they will continue to monitor the economic situation and adjust accordingly. Their ongoing decisions remain "data dependent." This means that if the markets or economy tank, it's possible that stimulus could be increased.
Will Yellen continue this approach? There is no way to know for sure, but she has been an influential member of the Fed, and I would say it's more likely than not. This shouldn't be used as an excuse to buy into the market, assuming the Fed will be there to avert any major downturns, but it is interesting to ponder.
Going into the announcement, stocks are relatively flat. The Dow as I write is up 22 points, the NASDAQ is down 23 and the S&P 500 is down 3. Treasuries have sold off today with the 10-year yield up to 2.881. Gold is up 7 and the dollar index is slightly positive.
The news is in: The Fed has decided to taper by $10 billion per month beginning in January. Treasury purchases and mortgage-backed security purchases will each be reduced by $5 billion per month. Tapering is not on a preset course; it will continue to be data dependent (this means the Fed Put described above is likely still in play). They are remaining quite dovish on rates, providing guidance that rates should remain low beyond the 6.5% unemployment rate that was previously targeted. In other words, the target unemployment rate has been set lower. The federal funds rate will continue to remain at or below 0.25%, and the Fed cites the lack of inflation as a facilitator of this move. Overall the decision was give and take; the reduction in bond purchases is offset by a continued and perhaps increased commitment to keep short-term rates low for the foreseeable future.
Some comments from the Q&A session that followed Bernanke's announcement:
When asked about Yellen's likelihood of continuing down the same path, Bernanke explained that Janet has always been a close consultant on all decisions including this most recent one. According to Bernanke, Yellen fully supports the decision today and is likely to carry on the same approach.
When asked about why no specific number was given when alluding to short-term rates staying low beyond 6.5% unemployment, Bernanke deferred to the well-known fact that the unemployment rate is influenced by multiple factors such as the participation rate. He notes that the Fed wants to take a holistic approach in identifying labor market improvement, taking into account other factors that determine the specific unemployment rate.
In response to other questions Bernanke said, "Highly accommodative monetary policy remains appropriate," referring to how the Fed's balance sheet will continue to grow, albeit at a slower pace, and that rates will remain low.
Bernanke also mentioned, "Monetary policy is not a panacea, it cannot solve all our problems," alluding to the fiscal issues that remain.
His concluding statements indicated that the QE program could possibly end by late 2014 if economic progress continues.
The following is an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.