Market Insights | September 2013

The Fed, and “Tapering”

Introduction Recently, much has written and broadcasted about major changes at the Bank, both in terms of personnel and policy. President Obama is close to nominating a new Chairman of the Federal Reserve to replace Ben Bernanke--whose term expires early next year. In addition, the Fed has talked about “tapering” the dollar amount of securities that they purchase each month. Below we discuss a brief history of the Fed, why Bernanke has been such a key leader and what “tapering” can mean to the economy and the financial markets.

A Brief History of the Federal Reserve System The Federal Reserve System (also known as the Federal Reserve, and informally as the Fed) is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the , largely in response to a series of financial panics, including a severe financial scare in 1907. Over time, the roles and responsibilities of the Fed have expanded and its structure has evolved. Events such as the Great Depression (beginning with the stock market crash in 1929) were major factors leading to changes in the system.

HSW Advisors | 505 5th Ave., 14th Floor New York, NY 10017 | 212-286-1170 The U.S. Congress established three key objectives for monetary policy in the Federal Reserve Act in that the Fed should:

. Maintain maximum employment . Sustain stable prices . Keep moderate long-term interest rates

The first two objectives are sometimes referred to as the Fed's dual mandate. Its duties have expanded over the years, and today, according to official Fed documentation, include conducting the nation's monetary policy, supervising and regulating banking institutions, maintaining the stability of the financial system and providing financial services to depository institutions, the U.S. government, and foreign official institutions. The Fed also conducts research into the economy and releases numerous publications, such as the Beige Book - a monthly survey of current economic conditions.

According to the Board of Governors, the Fed "is considered an independent central bank because its monetary policy decisions do not have to be approved by the President or anyone else in the executive or legislative branches of government, it does not receive funding appropriated by the Congress, and the terms of the members of the Board of Governors span multiple presidential and congressional terms.” (FAQs, “Who Owns the Federal Reserve”, the Fed Website).

The Fed and Inflation that began in the 1970s The Fed took on great modern prominence following the inflation of the 1970s. With the Kennedy and Johnson administrations of the 1960s trying to finance both the Vietnam War and a growing social welfare system, inflation became a new and ongoing problem in the following decade under the Nixon and Carter administrations. The rise in inflation was due to both fiscal and monetary policies in the US and was accelerated by other factors such as the quadrupling of oil prices in the 1973 Arab Oil Embargo.

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Source: "Historical Inflation Rates: 1914-2013." US Inflation Calculator. N.P., 15 08 2013. Web. 5 Sep 2013. .

Jimmy Carter was elected President in 1976 but was not successful in reducing inflation. The administration was further caught off guard with a second Arab oil price hike in 1979 in the wake of the Iranian Revolution resulting in higher oil prices and gas lines in the U.S. Carter appointed Paul Volker to Chairman of the Fed, and he began to focus on reducing the US inflation rate which peaked in 1980 at 13.5%. Volker’s principal tool in fighting inflation was to raise interest rates, which set the stage for a 30-year bull market in bond prices.

Volker continued to fight inflation until he was replaced by on August 11, 1987. Greenspan served for an unprecedented 18 years as Fed Chairman and also saw his role chiefly as keeping inflation in check. Greenspan was confronted with a crisis right after his appointment when the stock market plunged in 1987, but by and large he reigned during a period of acceptable levels of inflation, and a steadily rising stock and bond market. He is remembered for his comments about “irrational exuberance” and was proven right when technology stocks unwound after March 2000.

HSW Advisors | 505 5th Ave., 14th Floor New York, NY 10017 | 212-286-1170 3 Ben Bernanke and the Housing / Banking Crisis of 2008 Greenspan was replaced when George W. Bush nominated Ben S. Bernanke for the Fed Chairman position. He was sworn in on February 1, 2006 and will finish his second term on January 31, 2014.

Bernanke has become the world’s most influential central banker. Bernanke graduated Harvard and received his PhD from MIT where he studied under Stanley Fischer. Fischer, who recently retired after being the Governor of the Bank of Israel (Israel’s central bank), introduced Bernanke to the works of economists Milton Freidman and Anna Schwartz who focused on the causes of the Great Depression of the 1930s. His doctoral dissertation, “Long-Term Commitments, Dynamic Optimization, and the Business Cycle”, prepared Bernanke to understand what to do, and as important, what not to do, when confronted with a huge shock to the banking system.

As a former economics professor at Princeton University, Bernanke continued his studies in the area of fiscal crises and the banking system. Many academics and other central bankers believe that Bernanke’s lifelong study of central banking under stress meant that he not only knew the available options to confront the US housing and banking crisis of 2008, but he also understood that these options were not enough to get the US economy back on track.

For almost three decades the Fed was focused on keeping inflation in check, but in the wake of the financial crisis Bernanke forged a much broader vision of the Fed’s responsibilities. He started experimental and sometimes incomplete campaigns to reduce unemployment and to prevent future crises. In spite of all of the daring, untested and creative tools employed by the Bernanke Fed, it has not been fully successful in achieving its goals. Unemployment is still too high, growth is positive but weak and inflation is too low.

HSW Advisors | 505 5th Ave., 14th Floor New York, NY 10017 | 212-286-1170 4 Bernanke has taken the tack of communicating clearly about the future intentions of the Fed--termed “forward guidance”--reasoning that transparency and predictability would improve the Fed’s performance. This is in contrast to Paul Volker who argued that too much guidance would make investors overconfident, leading to too much risk-taking.

Bernanke has said that the crisis of the fall of 2008 was “the worst financial crisis in global history, including the Great Depression”. Though he had not seen it coming, he has been exceptionally aggressive and creative in new ways to stimulate the economy. He has declared that the Fed intends to keep short term rate near zero (the Fed Funds rate is currently targeted at 0% - 0.25%), until unemployment declines below 6.5%. Unemployment currently stands at 7.4%, down from its peak of 10.0% in October 2009.

Quantitative Easing and Tapering Bernanke has aggressively expanded the Fed’s balance sheet to engineer lower long- term interest rates that would help incentivize growth in the US economy. Through Quantitative Easing (“QE’), the Fed has been purchasing Treasury and mortgage-backed securities. The premise he employs is that low bond yields should stimulate home buying and mortgage refinancing, while allowing corporations to borrow at low interest rates to fund their capital investment and hiring plans. In the current program--QE3-- the Fed is purchasing $85 billion of Treasury securities and mortgage backed securities a month. These purchases are unprecedented and have ballooned the Fed’s balance sheet (see graph below), however, in May Mr. Bernanke announced that the Fed may begin to “taper” its purchases in the near future depending on the trajectory of economic data.

HSW Advisors | 505 5th Ave., 14th Floor New York, NY 10017 | 212-286-1170 5 U.S. Credit Outstanding (EOP, $Bn)

$4,750 Taper to: $4,500 Hold m/m purchases at +85Bn m/m +65Bn m/m $4,250 +35Bn m/m $4,000 $3,750 $3,500 $3,250 $3,000 $2,750 $2,500 $2,250 $2,000 $1,750 $1,500 $1,250 $1,000 $750 Projections

$500

Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14

Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Sep-12 Sep-13 Sep-14

May-05 May-06 May-07 May-08 May-09 May-10 May-11 May-12 May-13 May-14 Source: Strategas: Keep In Mind: Tapering Does Not Equal Tightening. 30 08 2013. 3.

This announcement sent the bond market into a quick decline. The 10-year government bond yield jumped from about 1.6% to the current yield of about 2.95%. The Fed effectively indicated to the world that the days of low and declining interest rates may be over. Interest rates have effectively been declining since the early 1980s, and as the economy strengthens, the Fed will reduce the liquidity it provides in the form of asset purchases. This explains why bonds have declined in value this year, but it is ultimately a sign about the building strength of our economy.

We liken expanding the Fed’s balance sheet to encourage growth in the economy to treating a sick patient by unorthodox measures. If the patient needs some form of life support, then weaning the patient off of the medicine is only contemplated when he / she is making a recovery. If the Fed feels confident that the economy is improving, then we should expect higher interest rates, a stronger US dollar, more foreign investment in the US and better trade flows. Over time this should result in more jobs and higher wages (although at this time the relatively low unemployment rate belies an underemployed workforce and the fact that many have given up on searching for a job.

HSW Advisors | 505 5th Ave., 14th Floor New York, NY 10017 | 212-286-1170 6 What Tapering Means for the Financial Markets In practice, tapering, depending on how much and how soon, should have little effect on the financial markets, but the perception of future tapering has already roiled the bond market. The cost of financing has increased by over 100 basis points based on the 10- year Treasury. Mortgage rates have also increased even though the Fed Funds rate still remains targeted at 0% to 0.25%.

When the 10-year Treasury yield rises, the value of those bonds decrease. However, that does not necessarily have a negative effect on the equity markets. In fact, quite the opposite has occurred. Since 1992, the 10-year bond has increased over 100 basis points 7 times (as outlined in the chart below), while in each case, stocks advanced.

10-Year Treasury and S&P 500 Returns when Yields Rose + 100 Basis Points 05/31/1992 – 06-30-2013 Increase of 10-year Change to 10- Change to Treasury (basis year Treasury S&P 500 Time Period points) 09/30/1993 – 11/30/1994 +253 -10.3% +2.2% 01/31/1996 – 08/31/1996 +136 -6.0% +3.9% 09/30/1998 – 01/31/2000 +224 -10.1% +39.4% 06/30/2005 – 06/30/2006 +122 -5.8% +8.6% 12/31/2008 – 12/31/2009 +163 -9.9% +26.5% 08/31/2010 – 03/31/2011 +100 -6.1% +27.8% 07/31/2012 – 06-30-2013 +105 -5.7% +19.0% Sources: Bloomberg, Morningstar, Citi Treasury Benchmark 10-Year Index.

In addition, since the US Dollar is the world’s principal currency, our higher interest rates have increased flows to the US Dollar and caused many emerging market currencies to decline against the dollar. That should ultimately stimulate their export businesses, but in the short run it has had negative effects on their interest rates and stock markets.

Perhaps the anticipation of tapering is worse than if / when it occurs. Consensus expectation is that the Fed will announce the start of tapering when its next two-day

HSW Advisors | 505 5th Ave., 14th Floor New York, NY 10017 | 212-286-1170 7 policy meeting ends on September 18. Our expectation is for a measured decline in purchases (initially to $65 - $75 billion per month) and for long-term interest rates to stabilize. Investors who added to cash positions in the summer of 2013 or have bonds maturing in the near term are likely to reinvest at these higher interest rates.

In the longer run, tapering without an increase in short-term rates should be positive for the stock market. In the big picture, private nonfarm payrolls have increased steadily for the last four years, the unemployment rate is down, manufacturing and spending are increasing and GDP growth has been revised upward based on better trade data. In other words, the economy is getting stronger.

There is debate as to the effectiveness of QE3. A number of research papers, including a recent report from the San Francisco Fed, have noted that QE is looking to be more costly and that the future benefit is minimal (FRBSF Economic Letter, August 12, 2013). Other tools, however, such as strong “forward guidance” on the Fed Funds rate (for how long and at what rate) should continue to be important but will have more of a market and media impact than a real boost to the economy.

We believe that the Fed telegraphed its tapering plans for two key reasons:

1. The federal budget deficit continues to show improvement. Revenues are up 12.6% year over year and spending is down 6.7% over the same time period. This has resulted in a $550 billion decline in the budget deficit since August 2012. The improving deficit has led to only $680 billion of total Treasury issuance over the past year with the Fed purchasing Treasuries at an annual rate of $540 billion per year.

2. Tapering, sooner rather than later, gives cover to the new Fed Chairman who may decide to continue this policy when sworn in on February 1, 2014.

HSW Advisors | 505 5th Ave., 14th Floor New York, NY 10017 | 212-286-1170 8 Summary of the Fed and Tapering In summary, the Fed was instituted about 100 years ago to provide central banking services for our country. One of its key mandates was to keep inflation at a reasonable and acceptable level. This became our focus for almost 30 years until the housing bubble burst causing a near collapse of our banking system. Ben Bernanke, trained in studying stressful economic in history and their effects on the banking system, was perhaps the best person to sit at the helm of the Fed during this time period. Bernanke quickly changed the focus of the Fed to sustaining and stimulating the economy by incorporating new and bold tools. He has become the world’s most influential central banker and has done an admirable job at growing the economy and creating jobs.

The Fed – in conjunction with Congress and the Administration – has worked hard to stimulate the economy, and when the Fed believes that the economy can stand on its own, it will begin to taper its purchases of Treasury and mortgage bonds. This may be negative for bond prices, but a stronger economy should be good for equity prices.

What is next at the Fed? Who Takes Over for Bernanke? At this time the two front runners for this position are , the Vice Chairwoman of the Fed, and Larry Summers who was the Treasury Secretary under President Clinton from 1999-2001 and Director of the US National Economic Council for President Obama from January 2009 until November 2010. Both of them are highly regarded academic economists who spent the first part of their careers advancing the understanding of macroeconomic policy, and the latter part implementing it in Democratic administrations. Notably, this will be the first time in over 30 years that a Democrat will nominate the Chairman.

Ms. Yellen has little experience in financial markets and crises though she has recently immersed herself in financial stability oversight. Her views are a somewhat dovish, i.e., more concerned with unemployment than with inflation, compared to Mr. Bernanke.

HSW Advisors | 505 5th Ave., 14th Floor New York, NY 10017 | 212-286-1170 9 Mr. Summers has never been a central banker. Although his economics are close to Ms. Yellen’s, his personality is much different. He is an aggressive individual, and President Obama knows him better and appears to favor him. Liberal Democrats might think that his advocacy of financial deregulation in the 1990s is wrong for the Fed and the country today, but this attitude could endear him to Republicans who may find Ms. Yellen too dovish.

In the end, who becomes the new Fed Chairman may be more important to the financial press than to US taxpayers. As the US and global economies improve, interest rates are going to rise, and have begun their upward trajectory. This translates into negative returns for investors with long-dated Treasuries, but it should be positive for the equity markets. However, there will be other crises and tough challenges. Hopefully, whoever is confirmed will be as bold, forward thinking and creative as Ben Bernanke.

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