Diary of a Financier

“Tapering” reactions: What’s really happend so far & what will happen in the future

In Dissertation, Economics on Mon 17 Jun 2013 at 23:25

The Financial Times (FT) released a story today, claiming knowledge that the Fed will announce a reduction in the rate of their monthly QE purchases:

“Ben Bernanke is likely to signal that the US Federal Reserve is close to tapering down its $85B-a-month in asset purchases when he holds a press conference on Wednesday, but balance that by saying subsequent moves depend on what happens to the economy.”

While markets halved their gains intraday (down from 1% to 50bps) upon that FT publication, media outlets were fast to juxtapose it with John Hilsenrath’s (WSJ) from last week. My first thought was: ‘Why would someone with FOMC inside knowledge leak the story to a British newspaper and not one of America’s very own mouthpieces?’ Then, I went back and re-read Mr. Hilsenrath’s post. I found that he danced around the subject of QE tapering and whether or not it’s proximate, curtly focusing on the subject of policy rates (e.g. Fed Funds Rate):

“An adjustment in the program [i.e. tapering] won’t mean that it will end all at once, officials say, and even more importantly it won’t mean that the Fed is anywhere near raising short-term interest rates.”

Like an illusionist, Mr. Hilsenrath seems to have drawn our eyes to ZIRP-continuation in his left hand, while slipping QE-tapering up his sleeve with the right. His was a white lie of sorts. Specifically, he could’ve kept quiet—plead the fifth, so to speak. Instead he gushed about ZIRP, incriminating tapering by not denying its existence.¹ It’s entirely likely that the Fed served him that leak on a silver platter (as usual), and his reporting conveyed a different message to the public than was intended by the original source. Perhaps that’s why the FT got a stab at it, to prepare the public for an imminent announcement.

~~~~

QE is an extension of monetary policy at the zero-bound. For an empirical description, take this deconstruction of the current landscape:

The Fed Funds Rate is our nominal policy rate,² from which you can subtract inflation to calculate the real policy rate, which is currently negative (i.e. inflation exceeds interest rates). Since a move to negative nominal interest rates would be so politically unpopular, QE seeks to accomplish a negative rate-like environment by both/either reducing yields of other assets and/or increasing inflation via a consumer preference inversion (i.e. present supplanting future consumption). QE accomplishes this by creating an artificial supply squeeze in high quality assets, starting from the bottom with Treasury bonds, Agency MBS, all the way up the pyramid. As demand outstrips supply in the [otherwise] deep Treasury/Agency market, risk free rates fall. Crowded out of the increasingly expensive, low yield sovereign space, the private sector has an option: spend their savings, or chase yield all the way up the risk spectrum to investment grade corporates, high yield credit, blue chip dividend stocks, etc.

That was the theory. In practice, the private sector opted for the latter, choosing saving (chasing yield) over consumption, which is why households have seemingly overshot the downside in deleveraging, with the debt service/disposable income ratio at 35 year lows. Further, bucking the theory, it’s now empirically difficult to correlate falling interest rates Tsy & SPX performance with/without QEwith QE. Yes, the 10y yield ($TNX) went from 2.83 in March 2009 to 2.17 today, with a high/low range of 4.01 to 1.39 in between. But, Treasury prices were flat or down during all four, intermittent QE operations. So, the Fed’s balance sheet has more than tripled to >$3T, and the 10y yield has only dropped 66bps?! I’m not sure if you can look at the Treasuries/MBS the Fed has been buying and credit QE with any correlation or causation. However, the higher risk an asset, the more correlation to QEs can be observed.³ The lack of daily/weekly/monthly comovement between Treasuries and QE tells me that investors figured-out the dynamics of LSAP/POMO programs and the “Bernanke put”; thus they accordingly sold Treasuries/Agencies to chase yield up the risk spectrum during QEs 1-4 (risk on), then fled to safety after each ended (risk off).

If you understand the monetary system, that’s all a rather intuitive thought train. It would thus stand to reason that a tapering would produce the opposite effect. The only evidence anyone has to suggest otherwise is the recent rise in interest rates, which everyone seems to attribute to Mr. Bernanke’s own original “tapering” intimation. In reality, were you to arrange the current events in chronological order, you’d see the story differently.

For example, TNX’s one month rally from 1.63 to 2.27 began on May 3. At that time, the MSM explained the rise as a reflexive response to higher growth expectations. Mr. Bernanke didn’t utter the word “taper” until a Q&A session during his Congressional hearing on May 22, when he first made clear that tapering QE today would be unproductive, then hedged by saying it could happen over the next two FOMC meetings, if warranted by the data.

SPY v TY_F

SPY v TY_F

Intraday, markets were confused at first, but TNX closed higher and SPX lower. Month to date, TNX had already been rising at that point; in fact, it was half-way to its June high. In contrast, SPX hit an alltime high that day, after which it entered correction-mode. That dynamic is telling: both a rising 10y yield and rising SPX through the beginning of May affirm the “higher growth expectations” meme. The priceactions thereafter are telling too: TNX rose unabated; SPX pulled back but staged a couple rallies to end May. Economic data (like poor PMI) arrived to open June, and that’s when SPX really started hitting the skids… and Treasury prices rallied! That’s right, I’m suggesting that the slide in risk assets was due principally to poor economic data, not the taper threat, which may have merely exacerbated the selling pressure.

HYG v TY_F

HYG v TY_F

As a good control group, High Yield credit ($HYG) also corroborates this, because it outperformed Treasuries (due to lower duration) up until the bad PMI report rang on June 3, then vastly underperformed thereafter (due to credit risk).

Further, Gold ($GC_F) and Silver ($SI_F) are probably the most sensitive instruments to fluctuations in real rates, and both precious metals weathered May/June’s correction with flat performance.

So, there you have it: revisionist history falsely attributed the whole rise in rates to tapering.

~~~~

Since we’re this far along in the conversation, it’s worth mentally preparing for the taper here and now.

So, what would a taper really do to the economy? Net-net, almost nothing—except for possibly stoking a measured rise in mortgage rates that could resonate to housing. In reality, the federal government’s paring of the deficit, a fiscal measure, is the biggest exogenous intervention to have affected the economy. The deficit is the only thing really stimulating the economy. Deficit spending is the closest thing to money “printing”–as so many people habitually mischaracterize QE.

A reduction in QE impacts financial/capital markets a lot more than the real economy. So what would a taper do to markets? I painstakingly described the correlation between TNX and SPX herein for a reason. The fact of the matter is that investors in aggregate (i.e. the market) understand the true effect of QE. It’s a mechanism intended to drive down risk free rates by creating a supply squeeze in Treasury/Agency assets. But, mitigating the observable effect, enlightened investors effectively frontrun QEs by swapping their government securities for corporates (IG/HY/equity). This is yet another example that you can model your theories all day long, but you can never model human behavioral psychology. As aforementioned, QE ended up raising asset values, but not incomes/consumption, and therefore growth’s magnitude was limited.

Finally, the conclusion must be that a QE tapering will trigger a proportionate de-risking only if the economy stalls. Then, capital would reverse its flow back down the pyramid towards risk-free assets. The de-risking aspect is generally accepted, but a simultaneous flight-to-safety bid for Treasuries–with falling yields via bull steepening–is not. The nice thing for long term, risk investors is that the Fed will re-up QE were the economy to founder.

That said, I still don’t expect a tapering yet. (And, I still think Mr. Bernanke should exert pressure on the Treasury/Congress to stimulate the slow economy via fiscal means, rather than letting them defer to his monetary interventions [to save themselves from ideological constituents].)

I expect the economy to have sufficient momentum to warrant a taper soon enough, which again is positive for risk assets in the long term–after the initial skittishness is digested. We have a choppy summer ahead of us until the economic picture fully develops.

–Romeo

¹Mea culpa: I previously took his mention of “rising rates” as synecdoche for QE + ZIRP, yet my re-read suggests that he not only intended that confusion, but he was expressly focused on ZIRP.

²A more important policy tool is the Fed’s new Interest on Excess Reserves (IOER), a new capability the Fed gained in 2008

³A stark contradiction to this:
Infographic: Sensitivity of different asset prices to Fed balance sheet expansion | The Economist
…I think the difference of opinion comes from their looking at the geometric effect of QE from March 2009-present, and I’m looking at it more granularly (e.g. effect of QEs 1-4, OT & ex-QE).

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  1. Update…

    FT reporter Robin Harding balked after his article was published, tweeting:

    That tweet reveals just how speculative his article/assertion, “Fed likely to signal tapering move is close,” was. It would appear that Mr. Harding had no leaked, inside track.

  2. Another, different summary of the mechanics & misadventures of QE…

    Quantitative easing may be most powerful when it ends | The Telegraph (UK)

    “In QE, the Bank of England prints money to buy government bonds. That extra demand raises the price of government bonds. Because government bonds pay a fixed amount of money each year (the “coupon”), if the price is higher, the percentage return (the “yield”) is lower. If the yield on government bonds is lower, one might expect investors to buy other things instead of government bonds – eg by investing in shares, or even by literally buying new machines to make things. So one might expect that QE would have the effect of increasing investment in the real economy – chasing money out of government bonds into more productive assets.

    “However, there’s a hitch. The yield on government bonds may be poor, so an government bondholder doesn’t get much that way. But if there’s another round of QE, the extra demand may raise the price of government bonds further, so although investors in government bonds may not get much yield via coupon payments, they might make a tidy profit on the capital sum.

    “The upshot is that, as long as there might be more QE coming, far from money being chased out of bonds into real assets by QE, it might attracted into bonds… Thus, paradoxically, we won’t really know what QE has achieved until we stop doing it.”

    http://blogs.telegraph.co.uk/finance/andrewlilico/100024887/quantitative-easing-may-be-most-powerful-when-it-ends/

  3. […] while stocks rise per higher future earnings expectations.¹ Empirically, that’s a dynamic we experienced between May 1-22. If the market expects the Fed will miss its calendar guidance, Treasury yields […]

  4. […] the recent HYG pullback within context of the broader bond market.  Despite equity (risk) markets hitting the skids over the same period, HYG has managed to outperform higher quality bond indices like […]

  5. […] As I noted earlier this week (I & II), the way this market has been behaving, my subtext herein could be: ‘How I learned to stop worrying and love the taper.’  I’ve gone down that road before: […]

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