NEW YORK (TheStreet) -- Bank of America (BAC - Get Report) led large-cap U.S. banks higher Wednesday afternoon, with shares up 3.6% to close at $15.70, following the announcement of the Federal Reserve's plans to begin tapering its purchases of long-term bonds in January.
The broad stock indices rose considerably after the Federal Open Market Committee concluded its two-day meeting and announced the central bank would trim its monthly purchases of long-term U.S. Treasury bonds to $40 billion from $45 billion and reduce its monthly purchases of long-term agency mortgage-backed securities to $35 billion from $40 billion, beginning in January.
The Dow Jones Industrial Average
As part of its "QE3" efforts to hold down long-term interest rates, the Federal Reserve has been buying a net $85 billion in long-term bonds since September 2012. The FOMC said the reduction in net bond purchases to $75 billion was decided upon, "In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions."
The market yield on 10-year U.S. Treasury bonds had risen as high as 2.91% before the FOMC released its statement, but after the tapering was announced, the 10-year yield dropped a bit to 2.89%, up 5 basis points from Tuesday.
Recent positive economic reports considered by the FOMC included a revision in the estimate of third-quarter gross domestic product growth to an annual rate of 3.6% from the previous estimate of 2.8%, and the decline in the unemployment rate to 7% in November from 7.3%.
The FOMC also released economic projections, showing a "central tendency" of projections -- throwing out the three highest and three lowest projections -- of a GDP growth rate ranging from 2.8% to 3.2% and continued improvement in the unemployment rate to a range of 6.3% to 6.6% during 2014.
Both figures will be of great important to banks and their investors next year. Most big banks are expected to face continued pressure on their net interest margins next year, because the federal funds rate has remained in a historically low range of zero to 0.25% since late 2008. The FOMC made no change in this policy Wednesday, and repeated its past language that keeping the federal funds rate near zero "will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored."
Curtailing the bond purchases will drive long-term interest rates higher. But what most banks need to see expanding net interest margins and significantly higher net interest income is a parallel rise in interest rates, which will require the Fed to raise the target for the federal funds rate.
The U.S. unemployment rate improved to 7.0% in November from 7.0% in October. Recent inflation reports show annualized U.S. inflation running well below the Federal Open Market Committee's long-term goal of 2%, so it would appear there's no short-term pressure for the Fed to raise the federal funds rate.
San Diego State University finance professor and economist Dan Seiver isn't surprised at the timing of the Federal Open Market Committee's tapering decision, since "hey were warning they might do it and the economic data was coming in stronger, probably than they expected. So it was appropriate for them to start. Knocking $10 billion off wasn't a big surprise either."
In a phone interview, Seiver called the euphoric reaction among stock investors "a bit of an over-reaction, but for all of us who own stocks, it's great."
When discussing the federal funds rate, Seiver said, "What the Fed wants to do is transition away from quantitative easing and back to using short-term interest rates as a policy tool."
He expects the federal funds rate to remain in its current range "all of next year and probably into 2015, even if the unemployment rate gets down to 6.45%, contingent upon inflation staying very low."
Bernanke's Press Conference
Outgoing Federal Reserve Chairman Ben Bernanke in a press conference Wednesday afternoon said "the unemployment rate is probably the best single indicator that we have" of improvement in the labor market. However, since the FOMC is also considering job creation and labor participation rates as part of a "broad set of labor market indicators," Bernanke said "I expect it will be some time, past the 6.5%, before all of the other variables that we are looking at will line up in a way that will give us confidence that the labor market is strong enough to withstand the beginning of increases in [short-term interest] rates."