A taper is whatever the market says it is: James Saft

December 18, 2013

By James Saft

(Reuters) – Coming months will answer decisively a question the Federal Reserve insists is already settled: is a tapering a tightening?

Score one for the Fed today: it cut purchases of bonds to a monthly $75 billion from $85 billion, but paired the move with a confection of sweeteners which touched off a startling rally in equities and only a small increase in long-term interest rates.

“Tapering is not meant to be a tightening,” Bernanke said after the Federal Open Market Committee announced the move. “The Federal Reserve means to keep the level of stimulus more or less the same.”

To judge by the reaction of the stock market – with the Dow Jones Industrial Average closing up 292 points – the moves the Fed announced must qualify as a loosening.

That may be because in addition to shaving $5 billion per month off of the amount it buys of both Treasuries and mortgage bonds, the Fed hardened forward guidance to indicate that rates could remain near zero “well beyond” the time unemployment drops below 6.5 percent.

That depends, in part, on inflation continuing to run below the Fed’s 2 percent target.

That’s quite a nice little bonus, considering that the Fed’s own forecasts don’t see much danger of inflation going above 2 percent for several years. Traders are betting that the first rise in interest rates isn’t until July of 2015.

Bernanke also indicated that, if things roll along as he expects, they’d do about a $10 billion decrease per meeting, implying that we’ll be all done with large-scale asset purchases by the end of next year.

Zero interest rates are one thing, but market rates are quite another, and as the Fed decreases purchases, longer-term rates are likely to rise. Investors who get cash from the Fed for their bonds become more willing to take risk. As the Fed buys fewer bonds and gives out less cash, that risk-taking preference will diminish. That is a tightening and that tightening will have consequences.

That, in fact, is exactly what happened last summer, throwing a scare into risk markets, particularly emerging markets, and ultimately leading to the famed non-taper of September.

SHOW ME THE INVESTMENT

Some things have changed between September and now. The fiscal drag on growth looks less frightening next year, employment is firming and manufacturing, by and large, is doing well. All of those factors, however, are vulnerable to a rise in long-term rates.

The economy can withstand that tightening only if business investment kicks in and businesses start to invest in earnest, driving wage growth and employment. Gently higher long-term rates combined with more business investment would be positive, indicating a return to healthy growth. It would also drive inflation a bit higher, perhaps allowing the Fed to gracefully exit zero rates earlier than planned.

Based on the track record in recent years, none of this is assured.

So, if the economy does not kick it up a gear and the Fed carries on tightening while promising low rates for longer, who and what suffers?

First, housing. Mortgage rates will rise, especially given the hit to Fed mortgage bond buying. That will hurt the minority of actual owner/occupiers who are in a position to move financially. Higher long-term rates will raise the returns investors expect from housing, undermining the bid single-family houses have had from financial investors. I’d look closely at housing next year as mortgage rates go up.

Second, bond markets. Public bond markets are undeniably loose, with a huge erosion of terms and conditions also underway in private lending markets. That has kept weak businesses alive and helped to underpin returns from related markets like equities.

The taper spells an end to that, one way or another. Investors will have less cash on hand, marginally, and will be less willing to invest in a Payment in Kind note or junk bond. Again, if this happens while growth and investment take off, it will be fine. Some weak companies will fail, but many will improve in credit quality.

If it happens with growth still weak and investment low, an ugly cycle of tougher credit conditions, tough business conditions and more failures will ensue.

Let’s wait a couple of months before we judge the taper’s impact and what exactly constitutes a tightening. Janet Yellen may have a tough first year as chair in store. (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 and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

(James Saft is a Reuters columnist. The opinions expressed are his own)

No comments so far

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/