Nobody–literally nobody–expects a QE taper before March/April 2014. Consequently, from stocks to bonds, the market has kept rallying into YE13 here. Asset values everywhere have kept appreciating. Seeing, watching, and hearing all this, I continually reevaluate my thesis for 4q13 and 1h14. Everyone’s piling onto the same side of the boat here, which is perfectly attune to the “transition to Euphoria” I expect… but I have to evaluate my null hypothesis, second-guess myself, and try to disprove what I’ve worked so hard to approve. That’s the only way I know how to control for my biases and not wed myself to my point-of-view.
Isn’t this investor herding exactly what the Fed wanted to avoid in floating the taper balloon in the first place? Well, the 10-year (TNX) is ~2.52%. That’s up from a low of 1.61 in May (pre-taper talk), but down from a high of 2.98 in September (right before the taper deferral). In the FOMC’s September press conference, Chairman Ben Bernanke implied that taper-talk was a self-fulfilling prophecy, allowing the Fed to defer tapering because rates had tightened all on their own. Embedded in that implication is that the 10y @ 3% was too high–or at very least further tightening would unnecessarily burden economic growth. Thus, maybe a 2.50 10y is right where the Fed wants it…?
While the Treasury curve may be in a sweet spot for policymakers, risk markets have continued to rally unabated. The further out the risk spectrum you look, the higher prices you find. Investment Grade corporate credit spreads have widened a bit; High Yields’ have not; and the equity market has coiled its way to alltime highs with its risk premium eroding.
What makes me nervous about the here and now is that the Fed has to be seeing all the same signals I’m picking-up. Some examples:
- Margin debt
- Corporate leverage
- Momentum stocks
- Lending standards- subprime consumer and leveraged loans
- Investor sentiment
People talk about Janet Yellen like she’s a perma-dove, but they also forget that she was a lonely Cassandra in 2005/06, warning unto deaf ears of the economy’s excesses during the housing bubble. In a black and white world, her convictions for extraordinary monetary policy may categorize her as a Keynesian, but her trackrecord suggests she’s a bit more of a moderate. Perhaps she’s a realist who listens to her data, finding her signals through the noise–as opposed to pushing her dogma like her predecessors. Perhaps she nips capital markets’ excesses in the bud this time. Once bitten, twice shy? With the pang of our last credit crisis still so fresh in the minds of many, I think we have reasonable grounds to expect as much–given a recency effect and experiential hindsight bias beholden to regulators.
Nonetheless, that characterization of Ms. Yellen is mere speculation, as is trying to game the Fed’s psychology. The only value of this thought exercise is in acknowledging the potential scenario, probabilistically weighting the outcome accordingly. Accordingly, we should reduce our risk-asset overweight to benchmark-weight as we approach December–all else being equal.
Here’s a bit of post ex-ante context…
The market sold off a bit today, as this language in the Fed minutes suggested that a QE taper may arrive earlier than expected–December or January, as opposed to the March/April timeframe previouslty expected:
“Taking into account the extent of federal fiscal retrenchment over the past year, the Committee sees the improvement in economic activity and labor market conditions since it began its asset purchase program as consistent with growing underlying strength in the broader economy.”
The takeaway so far is that the Fed sees the economy’s resilience in 2013 despite fiscal tightening as evidence that 2014 will bring stronger economic growth, since the fiscal drag is waning. (Revisiting my thesis, I concur on the strong economic growth, which is why I expect a bear market without a recession next year.)