Mike’s Financial Pocket: Here Comes The Fed Taper!


This week is shaping up to be a big one for the financial markets and perhaps the economy in general. Starting Tuesday, the Federal Reserve’s Open Market Committee will begin its meeting to decide whether to slow its bond buying program — affectionately known as “tapering” or “the taper.”

My prediction: The Fed will begin to taper by a small amount ($5 – $10 billion/month) starting October 1, but will be vague as to when the next “step down” of the taper will be. This would suggest that bond purchases could fluctuate in either direction as the circumstances (i.e., jobless rate, jobs created, and inflation) warrant. I also think that the Fed will taper mortgage-backed securities less than Treasuries, or perhaps even increase them while decreasing Treasury debt purchases.

Why is this so important?

Some background:

I’ve discussed previously the extent of the Federal Reserve’s interference in the financial markets by purchasing bonds issued by the United States Treasury, as well as agency debt (particularly mortgage-backed securities) — euphemistically called “Quantitative Easing.” It has been going on since the depths of the financial crisis in 2008 with little interruption. By buying debt, the Federal Reserve can manipulate long-term interest rates by reducing the supply of bonds out there, thus artificially creating demand for them. Remember, when bond prices rise (due to increased “demand”), interest rates fall. Of course, the Fed has the direct power to set short-term interest rates such as the discount rate and the Federal Funds rate, which are the rates at which other banks can borrow money directly from the Fed. Such rates set the benchmark for other interest rates (such as the Prime Rate) in the United States and elsewhere.

Here are some charts relating to the Federal Reserve’s balance sheet (its assets and liabilities), with respect to Treasury debt, since 2002:

The spike in the grey-shaded area represents Treasuries purchased during the first round of Quantitative Easing. The second sharp increase was during “QE2,” the second round of purchases which began in late 2010. The squiggly sideways line represents “Operation Twist,” where the Fed simultaneously bought and sold Treasuries of different maturities. What I mean by this is the Fed purchased long-term Treasuries (like the 30-year bond) to increase demand and thus pull down interest rates and sold short-term Treasuries. So there was no net increase of debt. Finally, our current round of “QEternity” is represented by the last line which is spiking upward. If the Fed “tapers,” the line will still be pointing upward, but closer to one o’clock rather than twelve if you will.

Here’s a second chart, which shows the Federal Reserve’s balance sheet with respect to mortgage-backed securities since 2002:


As you can see, the purchases of mortgage-backed securities has been a sharp ride upward during the first two rounds of Quantitative Easing. This was followed by a dip and a reversal starting in 2012, where purchases have proceeded upward.

The numbers on these two charts are simply astronomical. Combined, the Federal Reserve has well over $3 trillion dollars of United States debt instruments on its balance sheet. This is simply unsustainable because of the specter of rising interest rates, which would increase the amount of debt service that the United States has to pay on money it borrows.

So, back to my prediction. Why do I think the Fed will (1) taper very modestly; (2) be vague about future moves; and (3) perhaps increase mortgage purchases?

The “taper” seems to be priced into the market. In June, the market sold off on taper fears and bonds have moved upward in yield since — meaning their value has dropped. Check out the drop in stocks the middle of June after the June 19, 2013 Fed meeting:


The big red block lines represent downward movements in stock prices.

Inversely, bond yields increased after the June Fed meeting:

10 year

The black blocks in the middle represent the big spikes in the yield of the 10 Year Treasury after the June Fed meeting.

I think that the market priced in a “taper” after the June meeting and, so long as the taper isn’t too much, the reaction shouldn’t be too crazy.

As for the Fed being vague about future increases or decreases in the “taper,” I think that in order to calm the stock market the Fed will provide assurance that it will stand ready to backstop the economy if things turn south. Whether this is good policy or not is a debate for another day, but one of the big criticisms of the Fed in 2008 by some smart folks is that the Fed waited too long to “come to the rescue” and thus turned a small downturn into a near-depression.

Accordingly, I think that the Fed will make it clear (as it has done in the past) that it will increase bond purchases if the need arises. In other words, the story of “Quantitative Easing’s” demise has been greatly exaggerated.

Finally, I think that the Fed may surprise the market by either not tapering its purchases of mortgage-backed securities or tapering them less than Treasury purchases. The reason for this is two-fold.

First, although figures and statistics are likely being manipulated a bit, the projected deficit is on track to be the lowest it has been since Obama took office. One of the causes, in my opinion, is the aftermath of “Taxmageddon” at the end of 2012. I’ve opined that people made tax moves before the end of 2012 in an effort to take advantage of the lower tax rates. Such actions created an increase in tax receipts for the Federal government — thus a lower deficit.

Second, interest rates on 30-year mortgages have really increased a lot over the last few months. Though the rates are still historically low, the average 30-year mortgage rate has increased from under 4% to close to 5% in a few months. That’s a big jump. Since the housing market is such a huge part of the economy, I think it is likely that the Fed will want to continue to support buying mortgage-backed securities rather than Treasuries.

Of course, in the long run it would be better if the Fed exited the market completely so booms and busts that would occur would not be magnified by government manipulation and interference.

As always, free markets are better markets.

* * *

Besides the Fed meeting this week, we can expect initial jobless claims (consensus of 341,000) and a revision to last week’s glitch in initial claims because of two states not reporting jobless data. Earlier in the week, we will have manufacturing data and consumer price index reports. A very busy week. Have a great one!

(Note: I’m not a financial adviser. I’m just writing my own thoughts here. This is not to be construed as a recommendation or advice to buy/sell/trade/short any stock, bond, etc. Do your own homework).