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Tricky Taper Timing

yesterday-spx

Yesterday, outgoing Federal Reserve Chairman Bernanke tricked the markets by announcing that they would start to reduce (ie, Taper) their purchases of government bonds starting in January. Most people believed that the Fed would begin to taper in March 2014 – I wrote on the blog that my view on the taper beginning was a first quarter 2014 start, which is in fact when the initial purchase the lower amount will begin, but I didn’t think they would announce it this month.

I also wrote that I thought the taper would bring some downward pressure on stock prices because any reduction in liquidity has historically been negative for the stock market. As you can see from the chart above, the market had a knee jerk reaction down but almost immediately it began a significant climb higher, ending the day at a new record closing level.

I thought it would be instructive to look at what has happened to the stock market historically when the Federal Reserve starts to restrict its monetary policy. So, below I have included a chart, courtesy of Lance Roberts, of the 18 times over the past 56 years that the Fed has tightened monetary policy and what has happened to the stock market rally that was going on at the beginning of their tightening cycle.

interest-rate-table-risingrates-121713

What we learn from this chart is that in most of the 18 cases, the stock market rally peaked four to six months after the beginning of the Fed’s tightening phase, with four exceptions taking a year or more. In all cases, the stock market peaked during the tightening or shortly after the Fed’s reduction in liquidity ended.

I think this information is pretty important, but we have a pretty major difference this time: in these past 18 instances, the Fed had not used Quantitative Easing (ie, the purchase of bonds as a way to print new money for the economy). So, to a certain extent, we are in uncharted territory and we will have to make some assumptions about the future.

As part of the Fed’s announcement, they stated that they would keep interest rates low for an extended period of time which means that absent any major economic upturn in the economy or increase in reported inflation, they will keep the current Zero Interest Rate Policy in place through 2015 and possibly 2016. This will continue to provide significant monetary ease that will offset the tapering.

However, what they did not address was the size of the Fed’s Balance Sheet. Their balance sheet is roughly $4 Trillion in size, up from under $1 Trillion at the beginning of their Quantitative Easing activities. The graph below comes from the St Louis Fed and show the exponential growth in their balance sheet during their QE activities.

fed-balance-sheet

What happens to our debt-based government, and in turn our economy, if they opt to not reinvest those bonds when they mature? Also, since the Fed has been the primary purchaser of our government debt during the QE time frame, will someone step up to buy the debt of the world largest debtor at the current level of interest rates?

Let’s take a look at what the 10-year Treasury Note did yesterday.

yesterday-tnx

When the Fed made its announcement at 2pm, the yield on the 10-year skyrocketed higher, then tumbled, and began to inch its way back toward where it was trading prior to the announcement. Today, the yield is all the way up to 2.93%, moving toward the psychologically important 3% level. Over the past 18 months, the yield on the 10-year has increased 88%, which means that the borrowing costs for our treasury have increased 88% during that time period as well. Any new debt that they incur (and at the $700million level of our deficit that is substantial) and on any refinancing of matured debt, the borrowing costs have nearly doubled over the past 18 months.

If the Fed begins to reduce the size of its balance sheet over time, I think logically, the only thing that can happen is that yields in the bond market will continue to move higher. At some point, that will impact the stock market in two ways: (1) borrowing costs for corporations will increase, negatively impacting the earnings per share of companies with debt on their balance sheets – and subsequently reducing their share prices; and (2) bonds become a more attractive alternative to stocks for investment purposes, reducing the P/E’s from currently near-record levels (see the graph of the Schiller P/E Ratio in the last blog post) to more average levels – and subsequently reducing their share prices.

The question is, as always, timing. Since we are in uncharted territory, we can only make educated guesses and watch the time-tested indicators we follow (you can check out past issues of this blog and you will find them discussed in-depth). We will likely be cautious, and act to raise cash in equity portfolios at the first sign the Fed is going to reduce its balance sheet or that bond yields have begun to entice income investors out of dividend-paying stocks and into bonds.

Until then, as 14 of 18 historic instances demonstrate, we still likely have some period of time where the stock market will continue to move higher as investors are not yet feeling the impact of higher interest rates. Since the Fed vows to keep its Fed Funds rate low nearly indefinitely, this period of time could be several months or longer. However, if the 10-year yield goes above 3% or 3.25% we may begin to see some movement out of dividend paying stocks into bonds, and that could happen sooner rather than later, as investors in the bond market get spooked and worry that there are no buyers willing to fund our treasury at current yield levels.

It’s tricky.


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And, for those of you that were looking for a Christmas video, here is one that you probably haven’t listened to yet this season:


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Here’s wishing everyone a Merry Christmas!

Mark