We were going to hold off on a more substantial piece until later this week until we came across an article that we could not pass up sharing with our readers. As you all know, when the Fed announced it would being at some point reducing QE or the purchase of Treasury and Mortgage Backed Securities, the market had a “tantrum” and drove fixed income yields higher. This included Treasuries, Mortgage Backed Debt as well as Emerging Market bonds. It was a rough time for long only duration heavy bond managers and investors.

Currently the thresholds for a taper are 7% unemployment(currently 7.2%) and for an actual increase in the Fed Funds rate, the rate of unemployment should be around 6.5%.  It seems then that the short end of the curve will remain anchored for now.

It seems as though 2% is the number for inflation and since it is “comfortably” under that at 1.2%, they have room to continue the current rate of purchases.

The guessing game on a taper continues daily as economic numbers are analyzed and the words of the ever consistent Fed officials are listened to by the minute to determine if the doves or the hawks are going to win.

The article from “zero hedge” cited Jan Hatius a top economist at Goldman who believes that Taper could begin in December based on two separate studies from two officials at the Fed. Basically, they need to taper based on new models but to keep the tantrum under control they will likely announce a lower threshold for increasing the Fed Funds rate to 6.% or even 5.5% unemployment.

The most basic conclusion we have is that they will keep short rates low to lessen the severity of the potential reduction in asset purchases. We do believe that the economic growth rates and labor force issues do not give the Fed much room to reduce purchases much even when they begin.

Lastly, if they are correct in the threshold 6% unemployment as the new level before raising short term borrowing costs, we believe it could be beyond 2015 before they do.

The bond battle is in the early innings.

Sincerely,

Tom Koehler, CIO

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