The Economy and Bond Market Radar (December 17, 2012)

The Economy and Bond Market Radar (December 17, 2012)

Treasury bond yields were higher this week as the Federal Reserve announced an additional $45 billion in quantitative easing (QE) this week. This was expected, but a surprise was the elimination of the pledge to keep rates low through mid-2015, which was replaced with numerical thresholds on unemployment and inflation expectations. The Fed also planted the seed regarding the removal of stimulus, saying that it would do so in a balanced way. This could be construed as slightly more hawkish than the market expected. The current QE program is now on pace to “print” $1 trillion per year until the economy improves. The chart below depicts the massive expansion of the Fed’s balance sheet that has already occurred and the likely path going forward.

Strengths

• The Fed remains committed to more monetary easing and regardless of how the “fiscal cliff” pans out, fiscal policy will become more restrictive. The economy is unlikely to be robust next year and inflation is likely to remain contained.
• Industrial production rose 1.1 percent in November bouncing back from Superstorm Sandy-induced slowness in the prior month.
• HSBC’s China Flash PMI for December rose to a better-than-expected 50.9, indicating manufacturing expansion.

Weaknesses

• The NFIB Small Business Optimism Index fell precipitously in November, likely driven by the election outcome and fiscal cliff concerns.
• Eurozone industrial production fell 1.4 percent in October after falling 2.3 percent in September.
• The bond market witnessed a modest sell-off this week even as the Fed upped the ante with additional quantitative easing.

Opportunity

• For fixed income investors, it appears the day of reckoning (sharply higher yields) is still well in the future.
• Homebuilding is expected to add to gross domestic product growth this year for the first time since 2005. Though home construction accounts for only about 2.5 percent of GDP, economists estimate that for every new house built, at least three new jobs are created.

Threat

• The “fiscal cliff” is front and center on investors’ radar. If a compromise cannot be reached, that would be a negative for the market and economy.
• Europe appears to be on the verge of another crisis, but policymakers continue to bicker, just adding to the uncertainty