Weekly Markets Commentary - December 18, 2012

David Joy — Chief Market Strategist, Ameriprise Financial

Fed keeps buying while waiting for a deal

Last week the Federal Reserve doubled down on its bond buying program, announcing the replacement of the expiring Operation Twist with $45 billion of additional purchases per month. It went even further, saying that the now combined total of $85 billion of monthly purchases would continue as long as the unemployment rate remained above 6.5 percent and inflation remained below 2.5 percent.

Due to the bond purchasing programs over the past couple of years, the Fed's balance sheet now totals $3 trillion. The latest Survey of Professional Forecasters by the Federal Reserve Bank of Philadelphia, published in November, anticipates that the national rate of unemployment will average 7.8 percent in 2013, 7.4 percent in 2014, and 6.9 percent in 2015. Assuming these forecasts are close to what will actually happen, this means that the Fed may be printing money and buying bonds for the better part of the next three years. At that pace, by the end of the third quarter of 2015 when the unemployment rate might be approaching the 6.5 percent threshold, the Fed's balance will total $5.8 trillion, or nearly double today's total. If you remember, the Fed began the financial crisis with a balance of $0.8 trillion. Of course, the Fed hedged its bet by putting a cap on the rate of inflation it would tolerate while it attempts to push unemployment lower. But clearly, it sees little risk of higher inflation during this timeframe, given excess capacity throughout the global economy and tame inflationary expectations. This timeline is consistent with the Fed's stated expectation that the policy will remain exceedingly accommodative into 2015.

On Monday of this week, the Treasury Department released October data on foreign holdings of U.S. Treasury securities. And, once again, China topped the list at $1.16 trillion, up slightly from September, although that total has barely budged all year as China seeks to diversify its holdings. Following in second place was Japan, with holdings of $1.13 trillion. Total holdings by foreigners were $5.48 trillion, a roughly eight percent increase since January. The Federal Reserve now owns $1.66 trillion of U.S. Treasury securities, a modest decline over the past twelve months. It also now holds $0.89 trillion of mortgage-backed securities.

So, the Fed is doing its part to energize the economy. Many would say it is doing too much. But, the Fed would like nothing more in its stocking this Christmas than a deal to avert the fiscal cliff, followed by a grand bargain to address the long-term budget deficit, to relieve some of the burden from its shoulders.

The latest news on the fiscal cliff negotiations offers some incremental hope for a deal. House Speaker John Boehner made some concessions on higher tax rates, but only for those with incomes in excess of $1 million, and on total incremental revenues up to $1 trillion, up from his previous position of $0.8 trillion. Late Monday there was news that President Obama would allow raising the tax hike threshold to income over $400,000—up from his initial target of $250,000—and gave limited ground on other Republican demands for spending cuts. Talks will continue this week.

The stock market seems to expect a deal. Since its recent low on November 15th, the S&P 500 has climbed over 5.0 percent, despite the uncertainty. Ten-year Treasury note yields have risen 18 basis points as well. The latest Gallup survey also shows that a majority of Americans expect a deal as well. At least we won't have to wait too much longer to find out if they are right.

Important Disclosures: