The Longest Journey Begins With Delaying The First Step

 |  Includes: TIP
by: Michael Ashton

Everyone expected markets to provide a lot of late-day volatility yesterday, and so they did. The Fed apparently doesn’t mind surprising the market with a non-consensus outcome when that surprise gooses stocks and bonds higher. Here are some (fairly unstructured) thoughts about yesterday's declaration from the Fed that there will be no “taper” in its QE program yet:

  1. This has nothing to do with the fact that there was a minor wiggle in the Employment data, some weakness in Retail Sales, and some other disappointments this month. If that is now the standard, that the Fed plans to expand its balance sheet without bound as long as growth is not smashing the cover off the ball, then we are truly lost for QE will never, ever end. This month’s numbers were all within the normal variation for economic data, which do in fact vary even when the underlying economy is not. The old standard was “ameliorate a deep recession.” Then Greenspan turned that to “resist even a mild recession.” And now, is the standard: “Robust growth no matter what the long-term cost?” I don’t think so, and so I reject the notion that the failure to begin the taper has anything to do with the growth numbers.
  2. Similarly, the inflation numbers cannot be the reason. Core inflation is now rising, and the Fed has previously recognized that some of the decline in inflation has been due to transient effects of the sequester. Median inflation has remained steady at 2.1%, which is basically the Fed’s long-term target. The cost of 10-year deflation floors in the market are at the lowest level since they began to trade in 2009 (see chart -- the price is in up-front basis points; source: Bloomberg and BGC Partners). So it isn’t a lingering fear of deflation that has the Fed concerned.

Click to enlarge

  1. The Fed speakers over the last month have had ample opportunity to shoot down the idea that taper would start at this meeting, which has been the consensus for a long time. None of them did so, implying that the Fed was comfortable with that consensus. But something changed in the last few days, and that is that the odds-on next Fed Chairman went from being Larry Summers to being Janet Yellen, who happened to be in the meeting yesterday. (Note, though, that no person who has ever held the office of Fed Vice-Chairman has later been appointed to be Chairman -- although Donald Kohn, since he was Vice-Chairman from 2006-10, would also represent a departure from this same tradition. However, he was not in the room.) Does this change the dynamic? Absolutely, since one reason Bernanke has started thinking and talking about tapering is so as to leave as clean a slate as possible so that the next Chairman wouldn’t have to start his term by tightening (sorry, I mean “reducing accommodation”) and scaring asset markets. Once Summers withdrew his name, Yellen’s vote got automatically much more important and the urgency to start the taper much less (since Yellen doesn’t believe there are any important costs to QE). Indeed, in his post-meeting presser Bernanke noted that the “first step” on a taper is “possible this year.” That is far to the dovish side of what the Street was expecting, but consistent with the notion that Yellen’s opinion will carry a heavy weight unless someone else is appointed to the post.
  2. Yellen said last June that the Fed’s objective is a quick return to full employment, and that Fed action might be justified “to insure against adverse shocks” (emphasis mine), or even if the Fed concludes that the recovery “is unlikely to proceed at a satisfactory pace.” So, perhaps I need to reconsider my point No. 1 above. Maybe that is the standard now.
  3. If in fact QE has no cost, then there is no reason to ever stop it. In fact, it should be accelerated. Most Fed officials seem recently to be coming to the realization that there is highly unlikely to be a costless economic remedy, even if they are not sure what the costs are or think they can be contained. Those people clearly have no voice any more, even though it appeared that those views in the last few months were gaining currency (no pun intended, since the dollar dropped to the lowest level since February after the announcement yesterday – a Fed that was edging however slowly to being more-hawkish than average was good for the dollar; a weak, more-dovish than average central bank will be worse for the dollar all else equal). This is pedal-to-the-metal time.
  4. TIPS got a lot more expensive yesterday, with the 10-year rallying 20bps to 0.475% and breakevens up 4.5bps one day before the Treasury auctions another slug of them. The auction ought still to go well, because caution has been thrown to the wind by our beloved central bankers. This is also good for commodities, and they rose yesterday led by precious and industrial metals. Is it good for equities? Well…
  5. Equity analysts are like puppies. They completely forget what happened five minutes ago and every experience is brand new. There is never any context. So stocks shot higher yesterday, with the S&P gaining 1.2%, because of the dovish Fed and lower interest rates. But over the last few months, as the taper grew closer and interest rates shot higher, all equities did was move to new highs. So, higher interest rates and a (relatively) hawkish Fed doesn’t hurt stock prices, but lower interest rates and a dovish Fed helps them? This may be why the Fed thinks that buying bonds keeps interest rates low and selling bonds doesn’t raise them. It’s a strange market-based notion of a perpetual motion machine. For goodness’ sake, let’s crank interest rates down 200bps, back up 200bps, down 200bps, and keep doing that and the stock market will be at 1,000,000 before you know it. Prosperity! But in fact it is probably more like a bicycle pump. Pushing down inflates the tire, pulling up doesn’t deflate it. It seems costless. However, if you keep doing that, eventually the tire will pop.
  6. Speaking of the perpetual motion machine, I enjoyed this little gem from the FOMC statement:

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative…

Really? It hasn’t worked recently. Lest they forget: the taper hadn’t started yet, but until now it was busy being discounted in the bond market. I don’t expect that merely continuing to buy bonds into the SOMA will push rates much lower again. We all know that this game ends, and we know how it ends. With 10-year notes at 2.70% I wouldn’t be selling them, but I also wouldn’t expect a massive rally to unfold. I would hold long positions in September and October, because those are the right months in which to hold bonds (especially with debt ceiling fight No. 2, Syria, Italy’s government disintegrating, and Germany’s election), but if the market gave me 2.45% to sell, I would sell.