Taper Tantrum Two

Call it Taper Tantrum Two.

Two of the 12 members of the Federal Open Market Committee suggested on Thursday that it’s time to raise interest rates, causing the Dow Jones Industrial Average to drop 254 points.

To get a better idea of how ludicrous this is, consider the following:

  • The two hawks represent a sixth of the board. The hawks will need to more than triple their numbers to represent a majority.
  • Stock ChartThe two Fed members were speaking at a Cato Institute event called, “Rethinking Monetary Policy.” The event was not called, “Seven More Years of ZIRP,” “Zero Everlasting” or “Bring on QE4.”  Why would anyone be surprised that they spoke in favor of a rate hike?
  • One of the two, St. Louis Federal Reserve President James Bullard, is an alternate member of the FOMC and has long been advocating for a rate hike. This is the guy who caused the Dow to drop 100 points when he suggested in June 2014 that interest rates might be hiked in the first quarter of 2015.  We tried to determine the role of an alternate member, but the Federal Reserve Board’s description is about as clear as a Fed policy statement.  The page says there are 12 members of the FOMC, but lists 10, as well as four alternates.  So how do they come up with 12?  These are the people who are managing our economy.

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Bad News – The Economy May be Recovering

“This is what it sounds like when doves cry.”

                                                                    Prince

Imagine this.  After more than five years of mediocre economic growth and a quarter of “negative growth,” the economy grew at a rate of 4.0% in the second quarter.

At least that’s what the Bureau of Economic Analysis (BEA) said.  The BEA previously estimated that the economy shrank by 2.9% during the first quarter, but has readjusted its analysis and now says that the economy shrank by 2.1% in the first quarter.Inventory

From 2.9% “negative growth” to 4.0% positive growth is a swing of nearly 7% in a span of just three months.

That’s quite a swing … but do you believe it?  After all, Q1 growth was reported at -1%, -2.9% and finally -2.1%, so how much confidence should we have in the BEA’s first report for Q2?

Meteorologists are often criticized for erring on the weather, but they’re forecasting.  The BEA is trying to tell us what happened more than a month ago – and still can’t get it right.

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The QE Apocalypse

The end is near.

The Federal Reserve Board has now put a date on the quantitative easing apocalypse, letting us know that bond buying will end in October – unless the central bank changes its mind, of course.

The October ending is not unexpected.  The Fed has been cutting back bond purchases by $10 billion a month since last year and it doesn’t take a math wizard to figure out that there will be nothing left to taper post-October.

Yet this news, reported in the just-released minutes to last month’s meeting of the Federal Open Market Committee, is being treated as a revelation.  It was, for example, the lead story in The Wall Street Journal, which typically doesn’t lead with news that was discussed last year and made official at a meeting that took place a month ago. Portugal

The real news, though, is what wasn’t discussed – the end of near-zero interest rates.  As a result, rather than pushing yields up and bond prices down, release of the meeting minutes had the opposite impact.

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The Market’s Missing Mojo

Easy money policy has its share of side effects.  The stock market continues to hit new highs, thanks to the Fed, but the level of risk that investors and taxpayers are exposed to also may be close to new highs.

The market for U.S. Treasuries, as one example, is a “risk on” market.  As Bloomberg put it, “Just because U.S. Treasuries look more and more stable doesn’t mean they are.”

Some may mistake a lack of volatility for low risk, but the lack of volatility appears to be the result of less liquidity, not lower risk, as the Fed has purchased trillions of dollars in bonds and banks are pulling back from debt trading. Bubble PE_0

Before the financial crisis, lower volatility resulted in more trading, but in this case trading volume has dropped.

“What’s happening instead,” Bloomberg reported, “is unprecedented central-bank stimulus has sent everyone into the same risk-on bets, while it’s also becoming more difficult to trade as banks shore up their balance sheets in the face of new regulations.”

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Polar Vortex or Recession Redux?

The recovery that wasn’t a recovery may have come to an end, as the Bureau of Economic Analysis reported that gross domestic product dropped by 1% during the first quarter of 2014.

Even with the drop in GDP, lower housing sales and continued high unemployment, no one is saying the economic is in a recession.  Perhaps when a recovery is as insignificant as the one we’ve experienced for nearly five years, the distinction between recession and recovery is insignificant.

The economy was in sad shape five years ago and it’s in sad shape today, in spite of record stimulus spending, bond buying, and warm and fuzzy messages from the President, Congress and the Fed.

Quarter-to-Quarter-Changes-in-Real-GDP-Percent-Change_chartbuilder-1But fear not.  The bar is so low now, even a baby step over it will look like a high jump.  At least that’s the opinion of PNC Chief Economist Stuart Hoffman who wrote, “I believe this real GDP decline, mostly due to the polar vortex, coiled the ‘economic spring’ even tighter for a sharp snap-back (boing!) this quarter, where I have an above-consensus forecast for a 4.0% annualized rise in real GDP.”

In other words, bad news for the first quarter is good news for the second quarter.  Stop me if you’ve heard that story before.

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The Fed Goes Long

Few investors today would consider investing in long-term Treasury bonds.

The yield curve, which measures the spread between interest rates for short-term and long-term bonds, is not as flat as it has been in recent years, but that’s faint hope for investors.

A 10-year Treasury is still yielding less than 3% interest.  If the Federal Reserve Board achieves its goal of pushing inflation up to 2%, the real interest on a 10-year bond purchased today will be under 1%, payable at maturity.yield-curve-investwithalex

If the Fed overshoots its goal and inflation moves higher, which is highly likely, a 10-year bond would produce a negative yield.  What’s the probability that inflation will remain lower that the current yield on a 10-year Treasury over that entire period?

The U.S. has not had a period when inflation remained below 3% for a 10-year period since the days of the Great Depression.  During the period of recession then slow growth that we’ve experienced since the financial crisis began in 2008, inflation has remained low and the Fed’s focus has been on fighting deflation.  But when the economy improves and normal growth returns, inflation is likely to move significantly higher, as higher inflation is a byproduct of a healthy economy.

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Fundamentally Flawed

Imagine if the outcome of a football game depended more on the weather than on the talent of the players.

Weather, indeed, can have an impact and should, but its role is usually to test the talents of the players, not to be the primary factor in the outcome.  When it is the primary factor, anything can happen.  In such cases, would you put money on the game?

The weather is not the number one factor affecting the performance of the stock market these days, but neither is the talent of the players – that is, the fundamental performance of publicly held companies.

In recent years, The Federal Reserve Board has held sway over the market’s performance via quantitative easing, although under former Chair Ben Bernanke, it was somewhat more predictable than the weather.AUDJPY

Now, with tapering under way, that may change (we’ll see, as many expect plenty of bond buying ahead).  Yet other world events may replace QE in determining the performance of the market.  That means potentially greater volatility than we’ve experienced in the easy money era.

It doesn’t take much to affect today’s global economy, especially when the impact of events is amplified by high-frequency trading.  Consider, for example, the impact of the falling yen and Australian dollar on the S&P 500.

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The Neverending Story

Why change?

It’s been more than five years since The Federal Reserve Board began its quantitative easing program.  We’ve had QE, QE 2, Operation Twist and the never-ending QE 3.  The Fed’s portfolio of bonds exceeds $4 trillion and it now owns more than a third of all bonds issued by the U.S. government.

The net result of this never-before attempted experiment in easy money policy has been a still slumping job market, growth around 2% vs. a non-QE average of 3.3% and a drop in personal income of 4.7% since the “recovery” began.  At least there hasn’t been any deflation.

Yet new Fed Chair Janet Yellen announced this week that she’s “staying the course,” continuing QE maybe forever.  Although she said she plans to continue tapering, too, she added that the bond buying program is “not on a preset course,” so perhaps The Fed may taper its tapering, creating an untapering by buying even more bonds.

After all, $65 billion a month doesn’t buy what it used to, even with today’s low rate of inflation.

The market reacted positively, with the Dow Jones Industrial Average jumping nearly 200 points.  Once again, just as it looked like the market was reacting to real business conditions, the Queen of QE proved that the market is still firmly under the Fed’s control.

What Ceiling?

Remember “The Neverending Story?”  The book, which was made into a movie, takes place in a fantasyland, in which a dark entity called “The Nothing” threatens to consume everything.  In the neverending story of QE, “The Nothing” could be The Fed itself, consuming every bond in sight, or the federal government, consuming everything and casting a pall of new regulations that threaten job growth and recovery.

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Paper Taper

So the taper begins in January.  Big deal.

That was the market’s initial reaction anyway.  In fact, the market viewed this week’s announcement as a positive, setting yet another record.  Conversely, when Fed Chairman Ben Bernanke first brought up the possibility of a taper in May, he sent the market reeling.  So talking about buying bonds has a greater impact than actually buying bonds.  Who knew?

Some believe the stock market rallied because The Fed made it clear that it will remain accommodative and that interest rates will remain near zero until the apocalypse.  That being the case, though, why did bond yields soar?  Go figure.Taper Impact

The taper announcement is not a big deal, though, because everyone knew it was coming – everyone except for the economists whose job it is to tell us when tapering is coming.  First they guessed wrong that it was coming in October, then they guessed wrong that it wasn’t coming in December.  Keep that in mind when you hear them tell you the economic benefits of more bond buying and more government spending.

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Taperphobia Hits Wall Street

A taperphobia epidemic has Wall Street in a panic yet again.  “Taperphobia” is an irrational fear of common sense.  Symptoms include a falling stock market, soaring bond yields and ongoing anxiety attacks.  There is a cure, but it’s expensive – it costs at least $85 billion a month, but that’s enough to cure all of Wall Street and send the stock market soaring.

Taperphobia was discovered by Federal Reserve Chairman Ben Bernanke in May, when he invented a new definition for the word “taper,” using it to describe the gradual slowdown of quantitative easing (another phrase he invented, which translates to “buying bonds forever”).Philly Fed

Symptoms of taperphobia subsided through calm reassurances of ongoing bond buying to eternity, but they returned in October, because most economists had predicted with absolute certainty that tapering would begin then.

It didn’t, so taperphobia subsided again.  But now, thanks to discussions by board members included in minutes of the Federal Reserve Board, many believe that tapering will begin soon.

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