Fed's targets imply rise in equity, dollar; fall in bond, gold prices

The US Fed’s targets imply rising equity markets, falling US treasury prices, strong dollar and falling gold prices. Keep these in mind when you position your investments in 2013.

The US Federal Reserve (Fed) announced in its meeting in December 2012 that it will purchase $45 billion of US treasuries every month starting January 2013. The treasury purchases are in addition to the monthly $40 billion mortgage backed securities (MBS) purchase under the Quantative Easing-3 (QE3) programme.

[caption id=“attachment_557464” align=“alignleft” width=“380”]  The Fed is targeting an unemployment rate of 6.5 percent (7.7 percent last month). Reuters[/caption]

The Fed is targeting an unemployment rate of 6.5 percent (7.7 percent last month) with an inflation rate tolerance of 2.5 percent and it will continue to pump in $85 billion of fresh money into the economy on a monthly basis until its targets are met.

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The Fed’s growth forecast for the US economy is 2.3-3 percent for 2013 and 3-3.5 percent for 2014. The Fed’s policy rate is at zero percent levels (0-0.25 percent range) and is expected to stay abnormally low for the next two years.

The low interest rates in the economy is seeing a bit of revival in the housing market with home resales in October higher than expected and prices of single family homes rising continuously since February.

The US economy has been adding jobs every month over the last two years and its unemployment rate has dropped from levels of 9.4 percent to levels of 7.7 percent over the last two years.

US equity markets have been one of the best performing markets in 2012 with the S&P 500 gaining close to 20 percent. There is a general sense of optimism among investors on the US economy and that optimism is reflected in the rise of equities there.

The fact that the Fed is pumping money into the system and with interest rates at close to zero percent, the US economy can definitely move towards the Fed’s targets.

Financial markets will position for an optimistic scenario in the US, though there could be a brief stutter if the impending “fiscal cliff” is not averted by January 2013. On the negative front, the loser will be long-term US treasuries as an inflation threshold of 2.5 percent for the Fed would mean that the current yields on the US 10-year bond is too low.

The US 10-year treasury is trading at levels of 1.73 percent, off by around 35bps from record lows. US treasury yields are reflecting continuous weakness in the US economy and lower future inflation rates. US treasury yields are also reflecting risk premium on account of issues of eurozone debt crisis on the state of economies and markets.

An improvement in the US economy will lead to risk premium going off treasuries and will also lead to investors shifting out of bonds into equities.

The US equity markets have not performed for over twelve years with S&P 500 returning a miserable 3.5 percent on an absolute basis. Low interest rates, high system liquidity, improving labour market and housing market conditions and a cash rich corporate sector are all growth boosters for the economy and for equities.

The dollar will reflect the optimism on the US economy and the dollar bears who were shouting from rooftops of an imminent collapse of the greenback will be forced to change their opinion and shift their money into dollar assets.

A stable to strong dollar coupled with well anchored inflation expectations are not good for gold and other commodities that are seen as hedge for currency debasement or rising inflation expectations.

Oil prices are expected to stay steady on the back of the US becoming almost self sufficient in oil. (Read ‘Saudi America is a game changer for India’ here ).

Arjun Parthasarathy is the Editor of www.investorsareidiots.com a web site for investors.