Federal Reserve to Reduce Bond Purchasing as China Experiments with Loose Lending

The Federal Reserve announced a cut to its bond purchasing program that caused Treasuries to fall and the dollar to strengthen. The Fed also said that the U.S. job market remained lackluster, with the economy improving at a “moderate pace”.

Stocks rallied on the news, while analysts said Fed Chairman Janet Yellen’s comments on the Federal Reserve Open Market Committee signaled a slow pace to rising interest rates, which could help equities remain strong for the rest of 2014.

The Federal Reserve announced a cut to its bond purchasing program that caused Treasuries to fall and the dollar to strengthen. The Fed also said that the U.S. job market remained lackluster, with the economy improving at a “moderate pace”.

Stocks rallied on the news, while analysts said Fed Chairman Janet Yellen’s comments on the Federal Reserve Open Market Committee signaled a slow pace to rising interest rates, which could help equities remain strong for the rest of 2014.

Slow Growth

Janet Yellen noted that the FOMC was not satisfied at the rate of recovery, which left enough room for the Fed to keep its Fed Funds Rate at historic lows, with rates for overnight lending between banks remaining below 0.25% as they have been set since 2008.

In previous comments, Yellen said that indicators of improvements in the labor market remained lackluster, and this meeting saw little change to that indicator. Additionally, Yellen said “there is no fixed mechanical interpretation of a time period” for the Fed’s timetable to raise interest rates on U.S. Treasuries.

In previous days of trading, stocks have fallen on the fear that the Federal Reserve could raise interest rates which could cause many investors to move away from stocks and into bonds. While Yellen refused to give any forward guidance on when interest rates would rise, the Fed stated that the Federal Funds rate is likely to be at 1.375% by the end of 2015. That was estimated to be 1.125% by the same time in June.

China Lending Grows

Stocks started the day strong on news that the People’s Bank of China would provide 500 billion yuan, or about $81.4 billion, in loans to encourage a soft landing for decelerating GDP growth in the export-driven economy. The news surprised investors, who had expected lending to slow, with fears of constrained liquidity causing growth to decelerate considerably.

Some analysts are interpreting the move as a large-scale stimulus program, which is the Chinese central bank’s attempt to stop the economy from weakening further as it attempts to transition from an export-driven to a domestic-consumption driven economy.

While analysts have seen a stubborn refusal amongst Chinese consumers to consume more, People’s Bank of China Governor Zhou Xiaochuan moved to encourage greater lending on Wednesday. In a surprise move, Xiaochuan will abandon previous plans to create deposit-rate caps that would dampen lending and domestic consumption.

While some economists said the move will lower funding costs for companies, others worry that the move means the Chinese government is delaying its promises to liberalize the financial system by deregulation lending restrictions.

In recent weeks, China has faced growing criticism that a lack of government guarantee and low lending costs could contribute to an increasingly unstable shadow banking system that could threaten the government economy. 

Currently, deposit rates are capped at 110% of official benchmark rates. Nonperforming loans in China have risen for three years consecutively, and now account for $113 billion. Some analysts believe that loosening restrictions on interest rates could cause a spike in rates to compensate for the growing defaults, which in turn could turn into a national crisis.