Thursday, September 19, 2013

The Septaper Surprise?

Matthew O'Brien of the Atlantic reports, Everything You Need to Know About the Fed's Decision Not to Taper QE3:
Ben Bernanke cares nothing for your portmanteaus.

After telling markets for months that it would soon reduce (or, in financial lingo, "taper") its bond-buying, the Fed surprised investors by not doing so today. It will keep buying $85 billion of bonds a month. At least for one more month. So much for the "Septaper" -- get it, tapering in September -- that most had assumed was a fait accompli.

Not tapering changed everything by changing nothing. See, the Fed didn't change how many bonds it's buying each month. And it didn't change its promise to keep rates at zero at least until unemployment falls to 6.5 percent. But since markets expected it to start buying fewer bonds, not doing so was a positive shock. Stocks jumped, and borrowing costs fell fast. Thanks, Helicopter Ben!

So why didn't the Fed taper like it had hinted it might -- and what does all of this mean now? Let's tackle that below.

Why no Septaper?
The short version is it didn't make sense. The longer version is it didn't make sense, because the recovery is still rotten — and might get even more so. The pointless and premature austerity of the past year has certainly kneecapped growth, but the even more pointless and potentially destructive wrangling over funding the government and lifting the debt ceiling could really cripple growth. The Fed won't be willing to withdraw any stimulus until House Republicans give up their fantasy of using a government shutdown or debt default as leverage to defund Obamacare.

But the Fed couldn't blame all of its problems on Congress. Some of them were its own fault. The other reason the Fed said it didn't reduce its purchases now is a "tightening of financial conditions" — in other words, higher borrowing costs hurting growth. But why have borrowing costs risen? Partly because of increased optimism, and partly because the Fed said tapering would happen soon! That's right: the hint of tapering was a reason not to taper now.So, as Justin Wolfers explains, not tapering was merely undoing its undue (and inadvertent) hawkishness from a few months ago.

So, when will the Fed actually taper?
Good question. Back in June, Bernanke had said the Fed would begin tapering at the end of this year, and finish sometime next year when unemployment was around 7 percent. But that 7 percent rule is now defunct. Bernanke said the Fed won't necessarily stop QE3 when unemployment is 7 percent, but will instead look at other labor market indicators as well. Why? Well, unemployment has fallen far faster than the Fed thought it would for the unfortunate reason that people have given up looking for work. In other words, the unemployment rate isn't capturing just how bad things still are — and the Fed realizes this.

Now, it's possible that the Fed could start tapering in October or December if House Republicans don't bring on a financial apocalypse, but it's no sure thing. Even if the debt ceiling is raised without any (or at least much) drama, the still-weak labor market could conceivably push tapering into the new year.

Tapering isn't tightening ... or is it?
Bernanke has long insisted that tapering is not tightening. What does that mean in English? Well, the idea is that Fed policy is getting looser as long as its balance sheet is getting bigger. So even if it's bigger at a slower pace than it was before, it's still getting bigger -- and policy is still getting looser. At least that's the theory.

But that theory looked questionable after just the suggestion of tapering sent markets tumbling.  As Gavyn Davies of the Financial Times points out, the Fed's taper talk made markets assume it would raise interest rates much sooner and faster than it had promised. Now, the question of when the Fed will stop buying bonds and when it will raise interest rates should be completely separate ones, but markets didn't see it that way. As Paul Krugman argues, markets might see QE as the Fed printing its money where its mouth is. That is, the Fed won't raise rates as long as it's buying bonds, and not buying bonds makes its promises not to raise rates less credible.

Bernanke seemed to concede as much. He said the Fed didn't taper, because it wanted to "avoid tightening" at a time when the recovery still needs help, and might need more soon.


The good news is the Fed avoided what would have been a big mistake. It's not cutting back its bond-buying yet and, just as importantly, its projections show interest rates rising only very gradually through 2016. The bad news is that "Octaper" is now a word. 
That's not bad for bad news.
Mark Thoma of the EconoMonitor blog also shared his reasons as to why the Fed delayed tapering:
1. Fiscal policy. The uncertainty over a government shutdown, how much additional austerity there might be, and so on made the Fed nervous about doing anything that might add to the negative shock from fiscal policy. Fiscal policymakers have performed terribly over the course of the crisis, and the Fed is the only game in town. It can’t take the risk of adding to the potential problems that fiscal policy might cause.

2. Inflation and unemployment. As I said already, inflation is too low and unemployment is too high. There are no signs of an acceleration in the recovery of unemployment, and no signs that inflation expectations are moving above the Fed’s long-run target. Since all signs point to easing, why do anything that might be construed as a negative shock?

3. The Fed is gun shy. The negative shock — i.e. the rise in long-term interest rates and the corresponding slowdown in housing and investment — when it first began talking about tapering surprised the Fed. Just talking about tapering led to an unexpected spike in interest rates and although it appears that tapering was priced into financial markets, why risk another surprise? I don’t think additional bond purchases are going to do much good for the economy, all that can be done has pretty much been done already, but there is the potential for a negative reaction from markets and with all the less than robust recovery, fiscal policy worries and the like, why take a chance?

4. Capital flight from developing markets. A investors have anticipated rising yields do to the Fed potentially beginning to unwind policy, capital has flowed from developing markets to the US causing problems for these countries. Those problems could feed back into US markets and make a slow recovery even slower, so why take that chance?
In my last comment, I went over three Fed tapering scenarios and stated that in likelihood the Fed would begin trimming its asset purchases but didn't expect anything dramatic. I was wrong and should have stuck to my May comments on why fears of Fed tapering are overblown.

In my opinion, what spooked the Fed wasn't domestic economics but another potential crisis in emerging markets which would reignite fears of global deflation. In that sense, we have dodged a bullet:
It would be a grave error, Evans-Pritchard suggests, for the Fed to start tapering bond purchases at a time emerging markets are facing a turn in the credit cycle (Brazil, India, Turkey, South Africa, Indonesia, Ukraine et al) and given the danger of another eurozone "debt spasm", as occurred at the end of QE1 and QE2.

"The Bernanke Fed has twice misjudged the global effects of premature tightening already, each time precipitating a credit and stock market crash within weeks, and each time forcing the Fed to capitulate. Third time lucky?"

Is the Fed's desire to extract itself from QE all about jobs and inflation? Or something else? A former Fed governor has warned the Fed will struggle to extract itself from QE if it delays until 2014, potentially drowning in losses on its US$3.6 trillion of bond holdings once yields rise. But perhaps the real problem is the legitimate concern of fuelling an asset price bubble, which is how we got into this mess in the first place. Total public and private debt levels are 30% higher as a share of GDP in advanced economies than they were in 2007, and a new problem is bubbles in emerging markets as well.

Thus the conundrum is as to which is the lesser of the evils. Does the Fed pop the asset bubble, thus triggering a ruinous slump? Or could the Fed maintain QE without feeding the bubble further?

"The root of our global crisis," says Evans-Pritchard, "is the [US]$10 trillion reserve accumulation by the emerging powers, massive over-investment in China, and extreme levels of inequality within the West... The combined effect is to create excess capital, and lack of consumption, pushing the global savings rate to a record 25%. This chronic disorder keeps blocking economic recovery. It is embedded in the structure of globalisation."
As I've repeatedly stated, the financial elite are petrified of deflation and will do whatever it takes to reflate risk assets in an attempt to stoke  inflation expectations. Think about what happened yesterday after the surprise announcement. Bond yields fell, the U.S. dollar got hammered, gold and commodities rallied sharply, emerging market bonds, stocks and currencies got a boost, and so did high dividend sectors like utilities.

The goal is to increase inflation expectations. In particular, a fall in the U.S. dollar raises import prices and boosts oil and commodity prices. This will also bolster emerging markets most of whom are commodity exporters.

Importantly, by maintaining its asset purchase program the Fed is sending a signal that it is still worried about global deflationary headwinds. This is why the initial knee-jerk reaction of a sharp rally in risk assets might be short-lived. If the market senses that deflation is making a comeback, you will see a violent retrenchment.

Going forward, it will be critical to see if leading economic indicators continue to improve around the world. If this is the case, bond yields will continue to rise even if inflation remains subsdued. But if leading indicators begin to falter or worse still, plunge, the next huge surprise will not be delaying Fed tapering, it could very well be expanding quantitative easing.

Of course, if this happens, it will really spook the market as the perception will be that the Fed has lost control. One hedge fund manager who runs a tail-risk fund keeps reminding me: "The day the market loses its faith in the 'Fed put' will be the scariest day of all."

But for now, everyone is rejoicing as the Fed will maintain its asset purchases. The big money was made in bonds and emerging markets, both of which suffered extreme moves following the May announcement. We shall see if there is any follow-through in the weeks ahead. Keep an eye on bond yields and emerging markets.

Below, Michael Gayed, co-portfolio manager at ATAC Inflation Rotation Fund, says the Federal Reserve no longer controls the U.S. yield curve. Michael was wrong about tapering but he is right that the Fed doesn't control the yield curve. He is now worried about a crash in October and wrote a comment, The Last Great Bubble, the "faith in the Fed to solve all problems." Indeed, this may very well be the last great bubble but like all bubbles, it will likely go on longer than anyone expects.