Opinion

James Saft

A taper won’t come cheaply

December 11, 2013

Dec 11 (Reuters) – 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.

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. (here)

“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 labor 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.

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 Yellan 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.

U.S. 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. (here)

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, Reuters columnist 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.
For previous columns by James Saft, click on )

(Editing by James Dalgleish)

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