As usual the
Federal Reserve media reaction machine has fallen for a poorly executed
head fake. It has been fooled by this move many times in the past
and for its efforts it has tackled nothing but air. Yet right on
cue, it took the bait once more. Somehow the takeaway from Wednesday’s
release of the June Fed statement and the Bernanke press conference
is that the Central bank is likely to begin scaling back, or “tapering,”
it’s $85 billion per month quantitative easing program sometime
later this year, and that the program may be completely wound down
by the middle of next year.
Although this
scenario is about as likely as an NSA-sponsored ticker tape parade
for whistle blower Edward Snowden, all of the market segments reacted
as if it were a fait accompli. The stock market, convinced that
it will lose the support of ultra-low, long-term interest rates,
and the added consumer spending that results from a nascent housing
bubble, sold off in triple digits. The bond market, sensing that
its biggest and busiest customer will be exiting the market, followed
a similarly negative trajectory. The sell -off in government and
corporate debt pushed yields up to 21 month highs. In foreign exchange
markets the dollar rallied off its four-month lows based on the
belief that Fed tightening will support the currency. And lastly,
the gold market, sensing that an end of quantitative easing would
eliminate the inflationary fears that have partially fueled gold’s
spectacular rise, sold off nearly five percent to a new two and
a half year low.
All of this
came as a result of Bernanke’s mild commitments to begin easing
back on permanent QE sometime later this year if the economy continued
to improve the way he expected. The Chairman did not really elaborate
of what types of improvements he had seen, or how much farther those
unidentified trends would need to go before he would finally pull
the trigger. He was however careful to point out that any policy
shift, be it for less or more quantitative easing, would not be
dependent on incoming data, but on the Fed’s interpretation of that
data. By stressing repeatedly that its data goalposts were “thresholds
rather than triggers” the Fed gained further latitude to pursue
any stance it chooses regardless of the data.
Yet the mere
mention that tapering was even possible, combined with the Chairman’s
fairly sunny disposition (perhaps caused by the realization that
the real mess will likely be his successor’s problem to clean up)
was enough to convince the market that the post-QE world was at
hand. This conclusion is wrong.
Although many
haven’t yet realized it, the financial markets are stuck in a “Waiting
for Godot” era in which the change in policy that all are straining
to see, will never in fact arrive. Most fail to grasp the degree
to which the “recovery” will stall without the $85 billion per month
that the Fed is currently pumping into the economy.
What exactly
has convinced the Fed that the economy is improving? From what I
can tell, the evidence centered on the rise in stock and real estate
prices, and the confidence and spending that follow. But inflated
asset prices are completely dependent on QE and are likely to reverse
course even before it is removed. And while it is painfully clear
that expectations about QE continuance have made a far bigger impact
on the stock, bond, and real estate markets than any other economic
data points, many must be assuming that this dependency will soon
end.
Those who hold
this belief have naively described QE as the economy’s “training
wheels,” (in reality the program is currently our only wheels.)
They are convinced that the kindling of QE will inevitably ignite
a fire in the larger economy. But the big lumber is still too dampened
by debt, government spending, regulation, and high asset prices
to catch fire. So all we have gotten is smoke. A few mirrors supplied
by the Fed merely completed the illusion. The larger problem of
course, is that even though the stimulus are the only wheels, the
Fed must remove them anyway as we are cycling toward the edge of
a cliff.
Although Bernanke
dodged the question in his press conference, the Fed has broken
the normal market for mortgage backed debt. While it’s true that
the Fed only owns 14% of all outstanding MBS (the “small fraction”
he referred to in the press conference) it is by far the largest
purchaser of newly issued mortgage debt. What would happen to the
market if the Fed were to stop buying? There are no longer enough
private buyers to soak up the issuance. Those who do remain would
certainly expect higher yields if the option of selling to the Fed
was of table. Put bluntly, the Fed is the market right now and has
been for years.
A clear-eyed
look at the likely consequences of a pull-back in QE should cause
an abandonment of the optimistic assumptions behind the Fed’s forecast.
Interest rates are already rising rapidly based simply on the expectation
of tapering. Image how high they would soar if the Fed actually
tried to sell some of the mortgages it already owns. But the fact
is, the mere anticipation of such an event has already sent mortgage
rates north of 4%, and without more QE from the Fed in the could
soon exceed 5%. Such an increase would deliver a devastating blow
to the housing market. More foreclosure will hit just as higher
home prices and mortgage rates price legitimate buyers out of the
market. Housing prices will fall to new post bubble lows, sinking
the phony recovery in the process. The wealth effect will work in
reverse, spending and confidence will fall, unemployment will rise,
and we will be back in recession even before the Fed begins to taper.
In fact, the
back-up in mortgage rates seen over the last month has already produced
pain in the financial world, with banks reporting a rapid collapse
in refinancing applications. With personal income and wage growth
essentially stagnant, individual buyers are extremely dependent
on the affordability that ultra-low rates provide. A 50% increase
in mortgage rates (an increase from 3.25% to 5%) would price a great
many buyers out of the market. Higher rates would also cool much
of the housing demand that has been coming from the private equity
funds that have been a huge factor in pushing up real estate prices
in recent years. Falling home prices would likely trigger a new
wave of defaults and housing related bankruptcies that had plunged
the economy into recession five years ago.
A similar dynamic
would occur in the market for U.S. Treasury debt. Despite Bernanke’s
assurances that the Fed is not monetizing the government’s debt,
the central bank has been buying nearly 70% of the new issuance
in recent years. Already rates on 10 year treasury debt have crept
up by more than 50% in less than two months, to over 2.4%. Any actual
decrease or cessation in buying (let alone the selling that would
be needed to unwind the Fed’s multi-trillion dollar balance sheet)
would place the Treasury market under extreme pressure. Since low
rates are the life blood of our borrow and spend economy, it is
highly likely that higher rates will lead directly to lower stock
prices, lower GDP growth, and higher unemployment. Since rising
asset prices, and the confidence and spending they produce, are
the basis for Bernanke’s rosy forecast, new lows in house prices
and a bear market in stocks will quickly reverse those forecasts.
Higher interest
rates and a slowing economy will be a a disaster for Federal budget
deficits. An increase in unemployment and a decrease in tax will
hit just as rising rates make it more expensive for the Fed to finance
new and maturing debt. Also the profit checks Fannie and Freddie
have been paying the Treasury will turn into bills for losses, as
a new wave of foreclosures comes crashing down.
It’s fascinating
how the goal posts have moved quickly on the Fed’s playing field.
Months ago the conversation focused on the “exit strategy” it would
use to unwind the trillions of bonds and mortgages that it had accumulated
over the last few years. Despite apparent improvements in the economy,
those discussions have given way to the more modest expectations
for the “tapering” of QE. I believe that we should really be expecting
a “tapering” of the tapering conversations.
I expect that
the Fed will continue to pantomime that an Exit Strategy is preparing
for a grand entrance, even as their time line and decision criteria
become ever more ambiguous. The Fed’s next big announcement will
likely be to increase, not diminish QE. After all, Bernanke made
clear in his press conference that if the economy does not perform
up to his expectations, he will simply do more of what has already
failed.
Of course,
when the Fed is forced to make this concession, it should be obvious
to a critical mass that the recovery is a sham. Investors will realize
that yeas of QE have only exacerbated the problems it was meant
to solve. When the grim reality of QE infinity sets in, the dollar
will tank, gold will soar, and the real crash will finally be upon
us. Buckle up.
June
22, 2013
