3 days till taper?
The Fed starts their last meeting of the year tomorrow and by Wednesday we should know if the Federal Reserve will taper (reduce their money printing, bond and mortgage buying, which is famously known as Quantitative Easing (aka QE)). Last week the odds were 34% that they would taper and are on the rise this week as recent government data (mainly jobs and unemployment) have boosted expectations. There is also the legacy issue for Bernanke, that is, finishing what he started. I am sure he, too, wants to leave on a positive note that the economy is recovering and that he can start the beginning of the end of his QE program. But will they taper?
3-days till taper?
The talk this week will mostly surround the Fed, Bernanke, Yellen, treasury yields, and, of course, the Taper. There are enough positives in the government data, deficit spending reduction, and a possible budget deal (waiting for the Senate vote) to justify a possible Fed taper.
Most of the media hype and politics around the taper are based on their dual mandate of inflation and unemployment. Certainly they are both improving (based on government data and results), the CPI has remained low and unemployment is falling. U3 unemployment rate now at 7%; however, it is not the Fed’s dual mandate that started the QE program and it will not be their dual mandate that will end the QE. QE was created because the laws of Supply and Demand would destroy the U.S. sovereignty and the dollar. QE circumvents the laws of Supply and Demand.
Supply & Demand (simple review)
Typically when governments raise money (selling bonds), interest rates are DETERMINED by market forces based on Supply and Demand, as well as the associated risk.
When a nation raises money they announce HOW much they are looking to raise and this determines the SUPPLY of bonds that will be issued. If there are few buyers for those bonds (DEMAND), the interest rate of those bonds increases until they can build enough DEMAND (buyers) to fulfill the SUPPLY of the gross issuance.
Several factors determine the DEMAND: how much the nation is trying to raise, how much debt the nation has, their credit rating, their default history, revenues, etc. All these factors determine not only IF they would buy the bonds, but also how much they should receive (the interest rates) for taking the risk of lending the money.
Well, this is typically how it works and we have seen this play out in Greece, Cyprus, Italy, Spain and other nations. As these nations face significant economic woes, the interest rate on their bonds skyrocket because the buyers expect more interest to offset the risk of lending the money to these nations. These governments can’t FIX or SET their interest rates on bonds because they do NOT print their own currency, they share a common currency and thus must let the market forces determine the interest rates based on Supply and Demand.
QE is the Federal Reserve’s method to bypass or ignore the laws of Supply and Demand. When the Federal Reserve SET short-term interest rates at ZERO to spur borrowing and spending, they also derailed the ability for the government to borrow money. No one was willing to lend the government money for ZERO interest in the midst of an economic crisis. I doubt anyone would lend at zero interest even there wasn’t an economic crisis. On top of the zero interest rates, the government was also ratcheting up their spending like never before with radical stimulative efforts, this flooded the market with government bonds. The Federal Reserve stepped in and started printing money and buying the bonds, because no one else would. The Federal Reserve also engaged in the long-end of the yield curve (long-term bonds) with their Operation Twist program that forced down yields by creating artificial demand.
It’s was the perfect storm, with epic levels of government SUPPLY of bonds and interest rates artificially set to zero, in the midst of a global economic crisis, there was little to no demand. China officially announced they would no longer buy more bonds (they just rolled their bonds as they came due), and other nations could not afford to buy bonds because they had their own problems. There were only two choices; let the interest rates float based on the laws of Supply and Demand, which would most likely see short-term rates rocket to 4% and long-term rates move up to 8% or higher, OR the Federal Reserve could step in and artificially set interest rates and print whatever money is needed to fulfill the government’s supply. Our nation opted for the Fed’s QE program.
QE can’t go on forever, as all it does is create debt and encourage more deficit spending. We must remember that we are doubling the actual debt even though we only measure one side of the equation. Every year as the Federal Government DEFICIT spends $1 trillion dollars, money is being lent to the government that needs to be paid back. Well, the QE program is lending that money from the Federal Reserve. Simply speaking, the government is creating $2 trillion of debt for each $1 trillion it borrows, because the Federal Reserve doesn’t have the money to lend, it is creating the money to lend and thus adding to the liabilities on their balance sheet.
As Fed President Fisher stated a few months back, by year end the Federal Reserve would be buying 100% of all government bond gross issuance. To sum up what he said, no one else can or is willing to buy the new issuance of government debt at zero interest and thus the Fed must create money to buy it.
The QE problem is simple; it is adding massive amounts of debt.
While the media and politicians are all focused on the unemployment and inflation “Dual Mandate”, the real math is the Supply and Demand for government debt. If the government can decrease their deficit spending, then the Fed doesn’t have to print and buy as much, and thus they can reduce their money printing and asset purchases (Taper).
This has everything to do with government deficit spending and almost nothing to do with unemployment and inflation, their “Dual Mandate”. In fact, at this point the “Dual Mandate” is nothing more than window dressing and makes for good political debate and conjecture.
If you look at the math, the equation is simple: SUPPY (government bonds) – DEMAND (QE) = the ability to taper. If the government’s deficit spending decreases, their supply of government bonds decreases, which means the Fed can reduce their asset purchases, “taper”. I don’t know how much easier I can explain this.
Courtesy of the Congressional Budget Office (CBO)
Will They Taper?
This question should not begin with WILL THEY, but rather CAN THEY. Based on the deficit spending, which has decreased from a combination of the sequester and also tax increase (payroll) this year, there is some room.
Now that we know there is room, the question is WILL they.
My belief is that Bernanke would like to taper for several reasons, the primary one being that it will be the last chapter in his legacy and he certainly wants to be remembered as the man who saved the economy with his extraordinary policies and when the economy was saved he started to unwind those policies. It would also, in many people’s minds, prove that Keynesian economic policies work and once and for all end the debate.
However, Yellen and President Obama don’t want a taper, in fact, Bernanke has been rumored to have had a falling out with the Administration. I think Bernanke has seen the risk of the QE beast he created and that it must end, and end soon, if it is not already too late. However, the administration, or even more Dovish Keynesians, believe that since nothing bad has happened (yet) QE needs to be ramped up to keep the boom going and to give the economy a bigger kick start. Paul Krugman is against any tapering and has stated that the government needs to spend more. Yellen, the next Fed Chair, similarly believes, but is not nearly as vocal as Krugman.
Bernanke in charge?
Bernanke is still in charge and I think this two day Federal Reserve meeting could be a very interesting one. Yellen might relent to let Bernanke taper, knowing that when she steps into power she can ramp it up again.
It will be known as a Bernanke Taper if there is one. It will most likely be very small, a token so that Bernanke can end the last chapter of his legacy on a positive note. However, will the market mark this the beginning of the end or see it for what it really is?
Personally, even if the Federal Reserve does have room to taper, Yellen and the Administration want to ramp up spending. They managed to do that with the current short-term budget deal, which includes an additional $60+ billion per year. For the Keynesians, it is not about Supply and Demand, it’s about the dual mandate, ideology, and government knows best.
Support & Resistance
INDU 15,600 – 16,000
We are getting a solid rally in the pre-market futures which could follow through and see a push-up to the 16,000 level before seeing resistance. A lot will have to do with the Fed’s meeting this week.
NDX 3450 – 3500
The tech heavy NDX is seeing a solid pre-market rally. I would look at 3500 as the resistance level.
SPX 1770 – 1800
Much like the Dow Jones, the SPX could see a spike up to that resistance area. The VIX is still up in the 15 range can could stay there until we hear from the Fed.
RUT 1100 – 1120
The 1120 area is something to watch. If we get resistance there we could see this market come back down to 1100. The driver will, of course, be the Fed decision.
I don’t see this market breaking out or selling off until we get the official word from the Federal Reserve on Wednesday.
No taper means this market could rocket and move higher. Sellers (BEARS) will step-away and that means we could see a short-covering rally. It will be a short-term knee jerk reaction, but we could see a solid rally.
Taper of any size means the market could read this as the end of the Fed money printing party. While I don’t believe it will be, because of the likes of Yellen, in the short-term we could see the market drop down to those support levels and even break lower.
For now the market will bounce between these ranges until we hear from Bernanke and the Federal Reserve later this week.
I thought I would leave you with this review of History.
Courtesy of wikipedia