As a municipal bond investor, which 2013 quarter did you prefer?
a) First quarter-the market was running to stand still.
b) Second quarter-dealing with June's "taper-tantrum."
c) Third quarter-market transitions from "taper- tantrum" to "taper-tiger."
Many investors may be inclined to select the first quarter because there was less market volatility. However, I would argue if you selected the first quarter you are: extremely conservative; close to retirement; don't like to hear client complaints; lazy; naïve; or unable to fairly assess risk versus return trade-offs. While the second and third quarters have been painful, market participants are finally beginning to be fairly compensated for risk.
When Quantitative Easing 3 (QE3) was announced in June 2012, we considered it substantially enhanced and more powerful than QE1 or QE2 given the plan would only sunset when meaningful economic improvement was exhibited through job creation. It was our impression that interest rates would rise to more normal levels based on two thoughts: 1) The economy would be strong enough to stand on its own when the Fed reduced QE3 and 2) the largest non-price sensitive buyer (the Fed) would have dramatically less market influence. A reduction of bond purchases is a natural evolution of this unconventional policy and one that the market should desire.
The Federal Open Market Committee (FOMC) surprised many investors when they decided not to "taper" their monthly bond purchases on Sept. 18th. Like the parents of a teenager, many investors were left to wonder, "what are they doing?". By not tapering bond purchases in September, the Fed can review more recent economic activity and analyze the economy's sensitivity to higher interest rates. Secondly, the delay allows them to view potential fallout from Washington's fiscal game of chicken. Finally, it surprised the markets and reiterated a very important message: Data will drive policy.
Like many others, I wish the FOMC had modestly tapered bond purchases. The pool of liquidity would still increase, but not at the same rapid pace. Over the recent past the Fed has overestimated job creation, economic growth and inflation. Its inability to effectively forecast any of these variables likely weighed significantly on the decision to delay any policy adjustment. However, the market was expecting a change in policy that had been previously communicated.
By not tapering, the Fed reduces its credibility and mutes the forward guidance it wants the market to rely upon. It is time to wean the market from the extraordinary support given during the crisis. Allowing these policies to persist will create bubbles or risks in other areas. By artificially keeping rates low, the Fed has chosen to benefit borrowers over savers. Of course this was necessary in the beginning, but what about now? One of the factors causing municipalities to struggle with pension plan funding is low discount rates. Low interest rates may naturally occur within a slow growth economy, but it is time to stop dictating extreme policies and begin transitioning back to a free economy.
What should investor's expect going forward? In a word -- volatility. Looking forward, volatility will likely increase in interest rates, fund flows, potential issuance, and municipal bond relative attractiveness. If you were uncomfortable in the second and third quarter of this year, you might want to take some Dramamine and grab an airbag. Things are likely to get even more interesting.
Scott McGough is director of fixed-income at Glenmede, an independent
investment and wealth management firm headquartered in Philadelphia.