Mike’s Financial Pocket: 3 Reasons The Fed Will Keep Buying Bonds And Mortgage Backed Securities

Back in September, I joined a multitude of other bloggers and pundits wagering a guess as to when the Federal Reserve might begin to reduce its Quantitative Easing program and buy less United States Treasury bonds and Mortgage-Backed Securities. Such a reduction in purchases is referred to as a “taper.” Like most of them, I was wrong. I predicted a small taper in September. The Federal Reserve opted to continue its purchase of $85 billion in Treasuries and Mortgage-Backed Securities in each of its meetings in September and October. The Fed meets again this week and some wonder if the Federal Reserve will announce a small taper beginning on Wednesday.

I opined that the Federal Reserve would not likely taper this year, at least until the following conditions were met, which I will now refer to as my “Stability Thesis:”

Bernanke made a reference to 2011 and the S&P downgrade of America’s credit. I think that he’s trying to remain non-partisan here, but he has a point. The market was shocked by the S&P downgrade. Shortly thereafter the market was shocked again by Operation Twist, which wasn’t full-blown QE, but a mere shifting of the maturities of the Fed’s bond portfolio by selling short-term Treasuries (increasing supply, decreasing demand) and buying long-dated Treasuries (decreasing supply, increasing demand).

The S&P dropped over 200 points — a massive move — after the debt ceiling debate pushed America to the brink and the S&P downgraded America’s credit.

The market dropped another 100 points (albeit briefly) when the disappointing “Operation Twist” was announced.

Bernanke does not want this to happen again. Therefore, I believe that the Federal Reserve will not taper until there is a longer-term resolution of the debt ceiling debate and, to a lesser extent, Obamacare.

In order for the Federal Reserve to begin to taper we need: (1) a sub-7% unemployment rate for more than one consecutive month; (2) Obamacare’s effect on the jobs market to be known or at least contained; and (3) no real possibility of a shutdown or debt default.

The question is: are we there yet? Not quite. Here’s why.

1. The economy is getting better, but not by enough.

I could create a laundry list of the problems with the state of the economy, from taxation to Obamacare to oppressive regulation. However, as I’ve opined before, despite all of the headwinds the economy is improving, albeit slowly. Is it possible that the Federal Reserve thinks that the economy has improved past the point of needing “extraordinary accommodation” of monetary policy via Quantitative Easing? It is certainly possible, since the unemployment rate (U3) has dropped to 7% (if you ignore the severe drop in the labor force participation rate and the broader U6 measurement, of course). Interestingly enough, the month before the Federal Reserve began Quantitative Easing (the program began in November 2008), the unemployment rate was 6.5% and moving sharply upward. Even more interesting is that the Fed’s target unemployment number is also 6.5% when it comes to interest rates. It’s almost as if the Federal Reserve wants us to return to where we were, at least in terms of the U3 figure, before it begins to consider ratcheting rates upward.

But when it comes to Quantitative Easing, we are at 7.0%. I think that any drop of U3 below 7% for consecutive months will put pressure on the Fed to consider tapering its bond purchase program. Are there any other factors? Of course. But this number is a big one. The other major factors? Read on, dear reader.

2. Obamacare’s unknown effects will delay the taper.

Another major factor in the Federal Reserve’s Quantitative Easing taper analysis is Obamacare. The full effect of Obamacare has not yet been felt because businesses have gotten a waiver (by means of a unilaterally issued executive branch delay of the so-called “employer mandate”) that requires businesses of a certain size to either provide heath insurance of a certain “quality” to its employees, or pay a penalty. There is no way to be certain what effect this will have on small business, except for the fact that burdensome regulations always have negative effects on business.

Will the Federal Reserve delay the taper until the employer mandate kicks in? Doubtful. However, I do think that the Fed will taper so slowly that it could hold off tapering or even increase bond purchases if the employer mandate causes chaos. Because it was delayed until 2015, the effects may not be seen until well into that year. However, if we have some particularly strong jobs reports over the next few months (enough to mitigate the negative effect Obamacare will have on the jobs market once the employer mandate takes effect), the Fed may feel that it has anticipated Obamacare’s effect on the jobs market and proceed with the taper — if the other conditions that I’ve set forth are also met.

3. The budget has been temporarily resolved (pending Senate approval), but not the debt ceiling.

I’m going to lay down a marker here: I do not think that the Federal Reserve will begin to taper at this meeting, or until Congress punts in a meaningful way on the debt ceiling. As I discussed above, Bernanke expressed major concern that Congress would permit a breach of the debt ceiling. That, combined with the Fed’s “mild” Operation Twist, caused a significant market shock. Bernanke (and Yellen) will not let that happen again.

Paul Ryan either sold his soul or is the wisest political operator out there, depending on your point of view. While artfully dodging that debate in this post, I will point out that should the Ryan “Budget” be passed, a shutdown would be off the table for quite some time — until 2015. There are positives and negatives to this, but for the Federal Reserve, eliminating the possibility of a shutdown would certainly help with my whole “Stability Thesis.”

The problem is that the debt ceiling debate is still an issue. If Congress resolves the debt ceiling debate for an extended period of time (more than one year), that may be enough for the Fed to consider tapering.

Of course, my Stability Thesis for tapering does not factor in something extraordinary, such as a market shock or a large uptick in inflation. But — all other things being equal — if we get more than one month of sub-7% U3, the ability for the Fed to feel that it is able to anticipate Obamacare’s effect post-employer mandate, and a debt ceiling/budget resolution well into 2015, we can expect the Federal Reserve to cut back on its bond purchase program.

For me, the debt ceiling is the biggest trump card here. Based on what happened in 2011, I feel that the Federal Reserve can claim to have enough cover to avoid tapering in the face of a potential debt default.

As always, free markets are better markets.

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The Federal Reserve meets Tuesday and Wednesday, with its announcement due at 2:00 P.M. EST. Besides that, keep an eye on housing starts (due Wednesday morning), retail sales and the first-time claims report due out on Thursday (consensus 337k).

Have a great week!