Tapering Is Now TighteningJuly 22, 2014
For a long time, as we saw it, tapering and the threat of tapering (as in last year’s taper tantrum) did not constitute tightening. Today we explore why we believe the situation has now changed.
In order to understand why tapering was not tightening initially, we must momentarily set aside all influences on US Treasury note and bond interest rates that fall outside of the Federal Reserve’s program. Pretend for a minute that foreign exchange flows, geopolitical risks, inflation expectations, deflation expectations, sovereign debt biases, preferred habitat buyers and a million other things are all neutral.
Let’s think of it this way. The federal deficit was $1 trillion, and the Fed was buying securities at the rate of $85 billion per month, or approximately $1 trillion yearly. Thus, the Fed purchased the entire amount of issuance that the federal government presented to the market. If all things were otherwise neutral, the market impact was zero. There was no influence to change interest rates; hence they could stay very low.
But in the economic recovery phase, the federal deficit commenced shrinking sooner than the Fed commenced tapering. There reached a point at which the Fed was acquiring more than 100 percent of the net new issuance of US government securities. At that point, the Fed’s buying activity was withdrawing those securities from holders in the US and around the world. Essentially the Fed was bidding up the price and dropping the yield of those Treasury securities, and it was doing so in the long-duration end of the distribution of those securities.
The Fed has taken the duration of its assets from two years prior to the Lehman-AIG crisis all the way out to six years, which is the present estimate. It is hard to visualize the Fed taking that duration out any farther. There are not enough securities left, even if the Fed continues to roll every security reaching maturity into the longest possible available replacement security. We can conclude that the duration shift, otherwise known as a “twist,” is over. A six-year duration of the Fed’s balance sheet is about all one can reasonably expect them to obtain.
Now the Fed commences the tapering process, incrementally stepping down its purchases of $85 billion per month to lesser amounts. The Fed has said that it will complete that task and reach zero before the end of this year. The target month is October. The current rate of purchases is $35 billion a month, or approximately $400 billion at an annualized run rate.
The federal deficit has declined as well. Because of the shrinkage of the deficit, the run rate of Fed purchases and issuance by the US government are still about the same as the amount of Fed purchases. Before, the balance was $1 trillion issued and $1 trillion absorbed by the Fed. Presently, it is approximately $400 billion issued and $400 billion absorbed by the Fed. The Fed is on a glide path to zero, but the deficit remains a long way from zero. In July, August, September and October of this year, for the first time, the net issuance of US government securities will exceed the absorption by the Fed as it tapers.
The process of tapering is a gradual one that has been discussed by Fed officials continuously, and it is clear that, in the absence of some extreme reaction, they are going to sustain this path. What does that mean?
By autumn, we will see issuance of US government securities at a rate of somewhere close to $400 billion annualized, whereas Fed absorption will be at zero. The Fed will continue to replace its maturities, but that practice will not add duration or supply any stimulus.
In July, August, September and October, for the first time, the change in rate between what the Fed absorbs and what the Treasury issues will result in a shift. That shift is a tightening.
The effect of Fed policy on US-denominated assets has been to create a continued upward bias in the prices of those assets. Stocks, bonds, real estate, collectibles and any asset that is sensitive to interest rates have had the benefit of this extraordinary policy for five or six years. That support is coming to an end.
The ideas and opinions expressed in this blog are those of the author, and they should not be perceived as investment advice or as any other kind of advice.
The preceding is an abridged commentary by Cumberland Advisors and has been reposted with permission of the author. Cumberland Advisors commentaries are available at http://www.cumber.com/commentary_archive.aspx.
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