QE Tapering: Why ‘Whether’ or ‘When’ Doesn’t Really Matter

Wardwell’s Weekly Market Report

Observations on the Capital Markets – Week Ended September 6, 2013

  • No war, equities rallied and bonds fell
  • QE Tapering: Why whether or when doesn’t really matter
  • Of interest across the global markets

No War, Equities Rallied and Bonds Fell
We didn’t go to war last week – what will happen is highly uncertain – but the perceived probability of an imminent U.S. attack on Syria seemed to drop as the week proceeded.

  • Equities rallied, led by the MSCI Japan Index (+5%) the MSCI Europe Index and MSCI Emerging Markets Index (each around +2%) and the S&P 500 Index (+1%).
  • Bonds fell on stronger economic data: Ten-year U.S. Treasury yields hit 3% mid-week, closing up 16 basis points (bps) at 2.94%; the 10-year TIP yield rose 19 bps to 0.87%. The BarCap Aggregate Bond Index was down about 1% for the week; the BofA Merril Lynch High Yield Master II index was about flat. This pattern (higher real yields, tighter credit spreads and stable inflation break-even spread) is entirely consistent with markets discounting stronger, noninflationary growth. Elsewhere, Japanese and German 10-year yields rose 7 and 10 bps, respectively (no concern). However, rising Portuguese bond yields are worrisome.

QE Tapering: Why Whether or When Doesn’t Really Matter
The Fed hasn’t tipped its hand, but most commentators seem to think the market has now priced in a $10-20 billion reduction in the Fed’s $85 billion/month quantitative easing (QE) program. However, consider this – it doesn’t really matter whether the Fed starts to taper QE in September or in October and it doesn’t really matter whether they start with $5 or $10 or $20 billion. We know that QE will probably end around the middle of next year, subject to continued moderate growth.

These are the words in the July FOMC minutes (emphasis added by me):
“First, almost all participants confirmed that they were broadly comfortable with the characterization of the contingent outlook for asset purchases that was presented in the June post-meeting press conference and in the July monetary policy testimony. Under that outlook, if economic conditions improved broadly as expected, the Committee would moderate the pace of its securities purchases later this year. And if economic conditions continued to develop broadly as anticipated, the Committee would reduce the pace of purchases in measured steps and conclude the purchase program around the middle of 2014.”[1]

“Almost all” confirmed that the Fed is (always data-dependent, of course) broadly comfortable with moderating the pace of QE later this year, tapering to zero around the middle of 2014. We know our probable destination, even if we’re not 100% clear on when we’re starting. Even today, there are probably at least “a few” participants who think the Fed should wait longer and at least “a few” who think the Fed should act now, but “almost all” agree that QE should end next year. Tactical decisions will be made along the way, but the course has been set.

Consider this: How much should it affect the prevailing level of interest rates if the Fed tapers by $20 billion/month instead of by $10?  Or by $5?  The incremental impact of the size and/or timing of the start of tapering on the real-life supply/demand balance of the bond market shouldn’t be enough to explain all this volatility.

 Of Interest across the Global Markets ….

  • In Europe, the European Central Bank (ECB) and Bank of England met, but made no monetary policy changes. The ECB’s forward policy guidance was that rates would remain at “present or lower levels for an extended period of time.”
  • In China, modernization continues as trading of Chinese government-bond futures started.  (In 1995, the government shut down the market because of insider trading and manipulation.)
  • In Japan, more positive signs—unless you’re a retiree. The Bank of Japan (BoJ), in its most optimistic statement yet, said “Japan’s economy is recovering moderately” and that government policies are encouraging companies to increase hiring and capital investment. Japan’s unemployment rate is at a five-year low, business sentiment and corporate profits as a % of GDP are at highs. BoJ Governor Kuroda urged the government to proceed with a large increase in the sales tax to protect its credibility regarding debt sustainability, and said the BoJ was ready to accelerate its QE program, if necessary, to offset the drag from the tax hike.  Comment: None of this is good for retirees. A sales tax—unlike an income tax—is a tax on people’s prior savings (wealth). QE-induced Inflation—particularly higher inflation than anticipated—is a tax on the wealth of bondholders.
  • In the U.S., other economic data was generally biased to the upside. August auto sales rose to volumes last seen in the spring of 2007. Construction spending rose and, as expected, July’s trade deficit widened as non-oil (auto and consumer goods) imports jumped. The unemployment rate dropped to 7.3%, but for all the wrong reasons.  The household survey (remember—it’s a small-sample survey and subject to loud statistical noise) had the labor participation rate falling to 63.2%, its lowest level since 1978.  As a result, the available labor force fell.  As a result, the unemployment rate declined.

[i] http://www.federalreserve.gov/monetarypolicy/fomcminutes20130731.htm

 Other Data Sources: The Wall Street Journal, Financial Times, Bloomberg.

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