June 27, 2013 - Public Employees Retirement Association of New ...

PERA Executive Investment Summary
May 2013
Monthly Outlook: ‘Terra Incognita’
Over the course of the perilous climb out of the depths of the dark recession to the economic recovery
during the last few years, the U.S. Federal Reserve’s fiscal policies and practices of quantitative easing
(QE) have taken various twists and turns leading to a grey area of terra incognita (Latin: ‘uncharted
territory’). The Fed has worked tirelessly since 2009 to provide unprecedented interest rate
accommodations bringing the rates to negative real levels and creating extensive liquidity injections to
stimulate the American economy. They have committed to battling deflation and held fast against
economic slippage by purchasing billions of dollars of debt and risky mortgage assets through a buy-back
program. Currently, the Fed is buying $85 billion of Treasuries and mortgage-back securities each month
in order to put downward pressure on borrowing costs and to help spur economic growth. The average
economic recovery expansion of a post-war period typically lasts 63-65 months. The U.S. is currently in
the 47 th month of the current economic recovery, assisted by the bond purchasing program; the bond
purchasing program that was never intended to be permanent, but as an emergency measure. Gauging
the full impact of Quantitative Easing (QE) measures has required a steel reserve of calm and patience.
In an attempt to foster a longer-term view for the remainder of the recovery and finding new techniques
to keep inflation low while paring back on aggressive monetary stimulation, the Fed has taken on the
discussion of tapering at their monthly bond purchases. Chairman Ben Bernanke told Congress’s Joint
Economic Committee on May 22 nd that the Fed ‘could scale back stimulus efforts in the next few
meetings’ if the employment outlook shows ‘sustainable’ improvement. He emphasized that any decision
would hinge upon the economic data and that the Fed is prepared to stop tapering or even reverse it, if
economic growth does not meet expectations.
On June 18 th & 19 th , the Federal Open Market Committee met to focus on when and how they will tackle
the process of retracting the QE and continuing the deleveraging process. The Fed has stated an
unemployment rate of 6.5% as its threshold for pulling back on monetary policy. This level is interpreted
as a healthy position in the recovery of the housing market and the economic impact of an improved
labor market. At which time a reduction or ‘tapering’ of the bond purchase program should be
implemented as an act of confidence in economic strength. Economic data has shown signs of a steady
recovery in the U.S., which has led to robust discussions among Fed officials. The current talks have
tentatively considered paring back the purchases from $85 billion to $65 billion per month possibly
beginning in October, and eventually to $45 billion per month in late 2014. The steady decline in easing
would last through 2015 in order to alleviate any potential spikes of inflationary reaction to the Fed’s
attempts at a smooth adjustment. Since a reduction in bond purchases hinges upon the unemployment
rate, movement towards the 6.5% threshold has been rather painfully slow thus far. The stock market
and the housing market are resurgent and job market participation has been inching up, but the
unemployment rate is still uncomfortably high. Even the most optimistic of economists hold the 6.5% rate
as a target further out in the 2014 & 2015 calendar than the Fed. Importantly, once the tapering has
been completed, only then will the Fed consider reassessing the interest rate and a possible move to
increase it for the first time since 2006.
The speculation over the unknown outcome of the discussions have led investors to recalibrate their
interest rate expectations and outlook in various markets; domestic, international and in particular,
emerging. Jim O’Neill, formerly of Goldman Sachs, has stated that concerns over changing Fed policy are
especially front-and-center for emerging market investors. The global bond market stands to be exposed
to high levels of market instability particularly for those countries with excessive account deficits and
uncertainty over resolving them. Turkey, India, Brazil, South Africa, Indonesia and Thailand have all
begun to feel the mounting volatility over U.S. interest rates. The market chatter over the Fed’s tapering
process is leading to rising Treasury yields and strengthening USD, which is contributing to the early
demise of the ‘great reach for yield’ trades which propped up the Emerging Markets. The emerging
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