Better economic data has pushed a tapering of bond buying by the Federal Reserve higher up the agenda – even as early as next week. A taper may come, but it won’t come cheaply.
James Saft
Reuters Columnist
Risky assets (that means you, equities) will be in the firing line.
Last week’s jobs data were encouraging, as are surveys of manufacturers, making sagging inflation the chief argument for delay.
“The Federal Reserve wants to taper. Wants very badly to taper, in my opinion,” writes Fed watcher and University of Oregon economist Tim Duy.
“The recent employment reports seem to be giving a green light, and I suspect they are coming around to the idea that the decline in the labour force participation rate is largely permanent at this point, which will only increase their angst about the asset purchase program.”
Duy concludes the Fed will put it off into 2014, and I tend to agree, but many others see a taper at next week’s Fed meeting as a live possibility.
One possibility, as discussed when a taper was anticipated in September, is a small, almost symbolic cut in bond buys to get the ball rolling.
“A small taper might recognize labor market improvement while still providing the Committee the opportunity to carefully monitor inflation during the first half of 2014,” St Louis Fed President James Bullard said on Monday. “Should inflation not return toward target, the Committee could pause tapering at subsequent meetings.”
Any announcement, be it in December or next year, will likely be accompanied by some form of blandishment – perhaps extended forward guidance of low rates – meant to keep the long end of the interest rate curve from rising too sharply and undermining growth.
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There are reasons to delay – inflation is too low and trending the wrong direction and the Fed is in the midst of a changing of the guard with the retirement of Ben Bernanke and the advent of Janet Yellen as chair.
While it is tough to say what and when they will do, it is a very fair bet to anticipate that bond buying will have its biggest impact on the way out in the same place it had its biggest impact on the way in – in asset markets.
Tough time
As highlighted by the Bank for International Settlements, credit markets are extraordinarily loose while the bank funding market is not fully healthy. If the bid for credit provision goes away in public markets we could easily see a rapid turn in credit which would have a ripple effect across other markets.
US housing is also arguably at an inflection point, with some signs of rapid softening in the hottest markets. If long rates go up, taking mortgage rates with them, that will accelerate.
A tapering and credit tightening would hit other risk assets, namely equities, at a vulnerable time. According to Thomson Reuters data, S&P 500 companies have issued negative guidance this quarter 11.4 times more often than they have guided expectations higher, the most negative such reading on record by a wide margin.
“If, as we suggested … last week, the margin cycle is turning down, profit forecasts over the next few weeks will be eviscerated,” Societe Generale strategist Albert Edwards wrote in a note to clients, arguing in support of his recession call.
Cullen Roche of Orcam Financial points out that when you look at the very strong gains made in stocks thus far this year, the vast majority has been driven by an increase in willingness to pay for earnings rather than an increase in the earnings themselves.
Of the 26.5 percent gain on the S&P 500 index, 4.6 percentage points are attributable to earnings growth and 21.9 percent to multiple expansion.
So there you have it. Quantitative easing, which has driven credit markets and other risky assets higher and looser, may be about to start going away. At the same time crucial supports, both to the economy and asset prices, such as earnings and real estate, are showing sudden signs of weakness, all at a time when investors are being very aggressive in what they are willing to pay for a given dollar of earnings.
It is not hard to construct a scenario in which the taper comes in, credit tightens, mortgage rates go up and very suddenly asset markets seem remarkably rich.
Heck, it sounds almost exactly like what happened last summer.
This year or next, the taper is probably going to come, and this year or next risky assets are not going to like it.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)