"You typically get these short-term freak-outs when you get hints of a sea change in monetary policy.” - Brian Levitt, economist at OppenheimerFunds
We need to give a hat tip to the New York Times for the title of our post this week. When they first affixed the words “Taper Tantrum” to a video released on June 17th, they likely had no idea how appropriate the phrase would be for what would ensue in the financial markets over the next several days. Neither did we, or anyone else we know of for that matter.
Last Wednesday afternoon around 2:00pm Eastern time Chairman Bernanke walked into a customary press conference to make an official statement and answer questions following one of the FOMC’s regularly scheduled two-day meetings. As is standard practice, market participants and the financial media were ready to parse every nuance of the Chairman’s statements in search of clues signaling the future direction of monetary policy - and this time around special attention was being given to anything related to the Fed’s prospective “tapering” of its current asset purchase program.
In general the FOMC statement revealed that the committee was less concerned with downside risks to the economy and labor market than they had been back in the fall when the latest round of QE was initiated. Along these lines they raised their economic forecast for 2014 and accelerated their projected pace of unemployment reduction. Nothing surprising here.
What took observers by surprise was that Bernanke went so far as to lay out a hypothetical timeline under which the Fed could begin tapering QE later this year and perhaps wrap it up completely by the middle of 2014. While no one was expecting him to be this explicit, he was careful to qualify the proposed timeline by stressing that actual policy shifts would be enacted in response to the economic data as it unfolded over the coming year. In fact, the following quotes almost suggest that Bernanke began back-pedaling as the meeting went on, trying to reverse the audience’s assumption that he was laying out a hardline plan for a stimulus exit.
“It's important to understand that our policies are economic dependent… I think one thing that's very important for me to say is that if you draw the conclusion that I've just said that our policies - that our purchases will end in the middle of next year - you've drawn the wrong conclusion because our purchases are tied to what happens in the economy.”
“I would like to emphasize once more the point that our policy is in no way predetermined and will depend on the incoming data and the evolution of the outlook, as well as on the cumulative progress toward our objectives. If conditions improve faster than expected, the pace of asset purchases could be reduced somewhat more quickly. If the outlook becomes less favorable, on the other hand, or if financial conditions are judged to be inconsistent with further progress in the labor markets, reductions in the pace of purchases could be delayed; indeed, should it be needed, the Committee would be prepared to employ all of its tools, including an increase in the pace of purchases for a time, to promote a return to maximum employment in a context of price stability.”
Comments on the FOMC’s website regarding Fed President Bullard’s reaction to the meeting seem to confirm that the FOMC committee was not intending for Bernanke to signal a pre-determined plan for exiting QE:
“President Bullard also felt that the Committee’s decision to authorize the Chairman to lay out a more elaborate plan for reducing the pace of asset purchases was inappropriately timed… President Bullard felt that a more prudent approach would be to wait for more tangible signs that the economy was strengthening and that inflation was on a path to return toward target before making such an announcement.”
Financial markets, however, have reacted in such a way that would suggest Bernanke’s hypothetical timeline is all but assured. Deutsche Bank stated the following in a research note,
“It is indisputably visible that financial market participants interpreted Fed-chief Bernanke’s latest comments as an announcement of tapering that would start near-term, although he didn’t express that. The most recent Bloomberg survey among economist confirms this, as 44 percent now expect the Fed to cut their monthly bond purchase program by $20 billon already at the mid-September policy meeting. Earlier in the month, the size of this group was just 27 percent.”
What was most surprising about how markets reacted was the fact that seemingly every type of financial asset sold off in tandem. Since last Tuesday’s close, stocks, commodities and bonds are all down by a similar magnitude at -4.9%, -3.9% and -4.9% respectively.* In essence, we have seen a broad liquidation in which cash is king and “normal” correlations have temporarily been thrown out the window.
Morgan Stanley reveals this dynamic in the following charts of their Daily Sentiment Index. The chart on the left is the average sentiment reading for stocks, bonds, crude oil and gold while the chart on the right is the average of just stocks and bonds. These charts show the extent to which investors are liquidating everything and going to cash in response to the Fed Chairman’s comments. Note that the lows in these charts are more dramatic then at the height of the financial crisis.
As we pointed out in last week's Insight, "It is hard to quantify how much of the recovery over the past four years has been due to the normal cyclicality of the market and how much is attributed to massive monetary intervention." In a recent commentary, Doug Short echoed this thought when he suggested the recent selloff could be the beginning of a long overdue price discovery process in which the market attempts to reassign values to financial assets in a world absent of quantitative easing. In an op-ed on the Financial Times, PIMCO CEO Mohamed El-Erian agreed with this sentiment, saying that the cause for the past week’s turbulence was “the change in how markets perceive central banks’ willingness and ability to support artificial asset prices.” Clearly the knee-jerk reaction revealed what very few rational investors would disagree with: that there is at least some artificial value in asset prices as a result of the Fed’s aggressive monetary stimulus of the past four years. But is the market’s behavior over the past week signaling the beginning of a larger collapse in asset prices or merely short-term noise? We’re inclined to believe the market has overreacted and is being too aggressive in pricing in Fed tapering.
One of the fundamental underpinnings of the FOMC’s increased confidence is the recent activity in the housing market. On the margin more homes have been trading hands, building activity has begun to percolate and rising prices have improved the balance sheets and moods of American consumers. This has undeniably been driven by extremely low interest rates making more homes more affordable for more buyers. Although long-term rates are still low on a historical basis, a nearly 1% rise in mortgage rates will have a significant impact on this silver lining of the US economy – and the Fed knows it.
A more perverse view of the situation recognizes that whatever improvement the Fed is seeing in the economy is almost entirely dependent on the artificially higher asset prices created by record low interest rates and quantitative easing. Dr. David Kelly of JP Morgan said it well in a recent note,
“Sadly, the Federal Reserve may now be the victim of their own rhetoric. Having spent years over-hyping the benefits of QE, they appear to have convinced some market participants that the economy can’t get by without it.”
The economy is still in a precarious state in which even slight shifts in confidence can have material impacts on real growth – and there is no doubt that house prices and 401k statements directly impact confidence. In this way, perhaps by telegraphing to the market that we were on pace for an exit within the next year Bernanke thereby reduced its chances of actually coming to fruition. The taper tantrum could indeed become its own self-defeating prophecy, and history could show that we are in the midst of a fantastic short-term buying opportunity for assets such as long-term treasuries, high-yielding equities and precious metals. Alternatively, the economic recovery could continue or even accelerate in which case we would expect interest rates to rise even further while risk assets such as cyclical stocks and commodities regain their footing in the face of improving fundamentals.
The data releases in the coming summer months will be crucial as we head towards the Fed’s year-end meetings in September and December. We will carefully be watching employment and housing data for clues as to which direction the Fed may head, while also keeping an eye on developments in Europe and China for possible changes to the economic situation outside of the US.
* As measured by the SPDR S&P 500 ETF (SPY), the iPath DJUBS Commodity ETN (DJP) and the iShares Barclays 20+ Year Treasury Bond ETF (TLT) respectively.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
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