It’s no secret by now that recent comments by the Federal Reserve’s Chairman about “tapering” bond purchases has triggered significant turbulence in stock, bond and commodity markets around the world. The imbalances have been triggered by sudden withdrawal of carry-trade financing of simple, profitable trades–trades that are profitable only so long as the Fed remains “status quo” in its stance with quantitative easing.
The Fed’s official announcements have never wavered on the $85 billion a
month purchases…Chairman Bernanke only suggested “tapering” during Capital
Hill testimony when put to the question by a Congressman–and followed that up a week later at a news conference by stating that tapering
would only occur IF market conditions continued to improve with the
word IF emphasized.
So, for one thing, it seems that on the surface, markets over-reacted since the Fed has not done anything yet to slow down bond purchases from it’s $85 billion a month pace. The second thing to consider is that even when the Fed does start to taper (as soon as September according to some prognosticators), that it will only be slowing down its purchases to a smaller monthly number; it almost certainly won’t be ending its bond purchases “cold turkey.”
Yet, the world markets reacted to this tapering speculation as if the Fed had not only ended its bond purchases, but was out-right raising interest rates. Of course, Fed officials were wheeled out in the past few days to calm markets by telling the world that short-term interest rates would remain low (near zero) for an extended period of time.
Well, I say, of course!
(Image of the Federal Reserve Building, Washington, DC)
I personally believe that most people, including a number of market pros, do not really understand Fed policy or the complexities of how the Fed conducts its policy. A Case in point were the comments by esteemed money manager, Ron Baron on CNBC-TV this past week. Mr. Baron said he attended a private dinner where former US Treasury Secretary Tim Geithner spoke. According to Mr. Baron, the former Treasury Secretary said that the Fed would not end its QE (including tapering) for about 5 years.
When questioned about this, Mr. Baron was fairly certain that Geithner meant that tapering would not end for 5 years. Of course, most Fed watchers, including myself, were almost certain that Mr. Baron had misinterpreted the Secretary’s remarks. More likely, Mr. Geithner meant that the Fed would not raise short term interest rates for about 5 years and/ or begin to unwind its previous bond purchases of US Treasuries and Mortgage Bonds. As far as tapering goes, it would be almost reckless of the Fed to continue its quantitative easing program for 5 years. For one thing, the Fed’s balance sheet would balloon to a very dangerous point. Indeed, some Fed watchers (myself included), already worry that the balance sheet of the Central Bank is too large. It’s capital-to-debt ratio is more stretched than that of the world’s most shaky banks (at roughly a 2% ratio currently).
Second, another 5 years of quantitative easing (QE) would surely cause huge disruptions in world markets by continuing to prime an artificial carry-trade as well as exporting inflation to other parts of the world that may not want our exports of dollar cash infusions. Politically, the Fed would not be able to continue its QE program for as long as 5 years without incurring the wrath of many of our trading partners.
Now, I am not here to try and sound smarter than Ron Baron; the guy has proven to be an investing genius, by using a fairly simple formula over the years. He invests in under-valued companies that have strong cash flows and are priced with low earnings yield. His fund has returned handsome gains through smart investing, low turnover costs, and compounding returns. It’s not that this formula is something new, but few money managers have had the convictions of Mr. Baron to carry through with their investment plans in unwavering fashion and reward investors.Yet, the comments of Ron Baron about Fed policy seems to point to an interesting observation: even many professional money managers and otherwise smart financial types don’t fully understand how the Federal Reserve works or how it carries out its policies.
Tapering itself, concerns withdrawing (slowly) the bond purchases of longer-term debt instruments. This is why the 10-year treasury note and 30-year bond’s interest rates have spiraled higher in recent days, as they are long term bonds. Many forms of long term financing, such as mortgages, longer term corporate bonds, and auto loans with several years of payments have reacted negatively. However, shorter term financing, such as 30-day and 90-day corporate money market instruments have barely budged.
In other words, tapering affects longer term debt financing. This longer term debt is subject to bigger swings in the value of the bonds, because, a 100 basis point move in the interest rate on a 30 year bond reflects higher interest rates for up to 30 years, which is offset by a lower bond price over 30 years. (The prices of bonds and notes fall when yields rise, and vice-versa.) Contrast this to a one-year note where the interest rate affects the price of the note for only one year.
Now, another thing to understand is that before the Fed can begin an exit strategy (which means raising interest rates as the economy improves and also to control inflationary pressures), it must first end quantitative easing. This means the Fed must taper its bond buying program down to zero new purchases of long term bonds and continue with only its long term program of buying and selling short term notes.
However, The FED is trapped with a very limited EXIT STRATEGY–it’s
only tool for exiting its low interest rate strategy is to use Excess Reserves on deposit with its
member banks–the Excess Reserves strategy, though brilliant, has never
been tested in the real world. It is basically an unproven theoretical
strategy that the FED will use only if it’s back is up against the wall
in having to raise interest rates.
This leads up to the observation that the Fed likely floated a trial balloon recently to see the reaction of the world markets to the threat of pulling back the punch bowl a little. As we have seen, the markets have reacted rather violently to the loss of the QE stimulus, if even done slowly over many months. We have already seen how just the mere
suggestion of TAPERING has caused huge sell-offs in places like Japan
and the Emerging Markets where the Yen and Dollar Carry-trades help to
support the leverage in those markets.
Another observation: if the Fed allows
long-expiration interest rates to climb, then this raises the US
Treasury’s borrowing costs. Even with today’s very low interest rates,
the interest payments are the 4th largest item in the US’s
“budget”; imagine what would happen if interest rates on the 10 year
were to double to market fair value at 4%!!!
Through all of this exercise, there is one thing that is apparent… and that is that the Fed’s continuous stimulus of the US economy (and the world economy through the carry-trade function), has put markets in the precarious position of massive upset and dislocation at the very thought of ending “the sugar high” created by the US Central Bank.
The more I look at it, the Fed has no choice but to begin to taper its bond purchases, no matter how slight, to get markets use to the idea that they cannot always have a crutch to prop them up. Otherwise, the capital system of finance we as Americans have long known and which affects our daily lives in so many ways, is doomed.
What’s also worrisome, and little talked about by the financial media, is the Fed balance sheet. No one ever asks how the unthinkable could occur, but what would happen if there were “a run” on the bank–not just any bank, but a run on the central bank? Could it happen?
With an estimated less than 2% capital-debt ratio, what would happen if the depositors of the Fed’s capital were to suddenly demand their money back? I guess that amounts to understanding who the investors of this capital are?… which I assume are its member banks in the reserve system.
The Fed is all powerful, and the member banks always fall in line when the Federal Open Market Committee (FOMC) sets policy. Yet, I ask, what would trigger such an event? Is it unthinkable? It’s such a complex subject that no one seems to have an answer, or at least, no one who knows is willing to offer an answer. At
any rate, I think some members of the FOMC are beginning to pressure
Mr. Bernanke into curtailing his QE program before we have to find out
what could happen to the Fed’s own capital if it had to suddenly sell
some of its assets (bonds) before they reach maturity. A bankrupt
central bank would be the technical result.
Perhaps the answer is purely academic, because the Fed will always have its printing press and can create as many dollars and as much “capital” as it pleases.
In the end, the real result may some day be played out in the currency markets when other countries of the world become fed up with Fed policy. Based on recent strength in the US dollar and the fragility of world markets, it seems that day of reckoning has been delayed for a much later date–or at least that’s what the market pundits want us to believe. My concern is that in this fast-paced computer-driven financial world we live in, the world capital markets themselves may suddenly choose to dis-obey the voices within the government (and quasi-government) institutions that guide monetary policy. Value is in the eye of the beholder after all.
Anyway, I apologize for daring to think the unthinkable.
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