Tapering And Unemployment Are Like Apples And Oranges

Includes: EEM, HYG, TLT
by: Oriental Trader

These days, the debate is raging over the unemployment rate and miniscule changes in inflation and what that means for the Federal Reserve's QE policy. I believe such focusing on the trees misses the larger forest. Whether or not the Fed tapers may have very little to do unemployment or inflation rates and I'll attempt to explain my rationale in this article.

If we look back at arguments for tapering, whether by Fed officials or by other notables, there is a stronger focus on risks to financial stability than unemployment etc.

1) Fed acknowledgement of financial stability risks:

On May 10th, Bernanke mentioned in a speech that:

In light of the current low interest rate environment, we are watching particularly closely for instances of "reaching for yield" and other forms of excessive risk-taking... For the purpose of safeguarding financial stability, we are less concerned about whether a given asset price is justified in some average sense than in the possibility of a sharp move. Asset prices that are far from historically normal levels would seem to be more susceptible to such destabilizing moves.

Source: Bernanke speech,5/10/2013

Naturally this is not new. In March, Bernanke displayed similar sentiments:

To oversimplify, the first risk is that rates will remain low, and the second is that they will not. In particular, in an environment of persistently low returns, incentives may grow for some investors to engage in an unsafe "reach for yield" either through excessive use of leverage or through other forms of risk-taking ... Alternatively, we face a risk that longer-term rates will rise sharply at some point, imposing capital losses on holders of fixed-income instruments, including financial institutions

Source: Bernanke speech 3/1/2013

This is of course, in accordance with the overall theme of "the costs of QE". If you do a Google search on the exact phrase "cost(s) of QE" in the time period 2012, you'll find only a handful of results, mostly focusing on the potential inflationary consequences. But there are innumerable results for the phrase starting 2013.

This mirrors when the FOMC began mentioning "costs and benefits" in its minutes. In 2011, this was a moot issue. The "cost-benefit" language came up rarely in 2011, and the below is a rare example:

A few members remained uncertain about the benefits of the asset purchase program but judged that making changes to the program at this time was not appropriate.

Source: FOMC March 2011 Minutes

As late as mid-2012, the "benefits" being questioned were those resulting from Operation Twist:

Some members noted the risk that continued purchases of longer-term Treasury securities could...undermine the intended effects of the policy. However, members generally agreed that such risks seemed low at present, and were outweighed by the expected benefits of the action.

Source: FOMC June 2012 Minutes

In the July meeting before QE3, costs and benefits of more QE were being discussed:

Participants also exchanged views on the likely benefits and costs of a new large-scale asset purchase program...A few participants were concerned that an extended period of accommodation or an additional large-scale asset purchase program could increase the risks to financial stability or lead to a rise in longer-term inflation expectations.

Source: FOMC July 2012 Minutes

Henceforth, costs and benefits of QE were mentioned in every FOMC minutes. More significantly was the change in language, for example, December 2012 minutes were still talking about:

With regard to the possible costs and risks of purchases...could complicate the Committee's efforts to eventually withdraw monetary policy accommodation, for example, by potentially causing inflation expectations to rise or by impairing the future implementation of monetary policy.

Source: FOMC Dec 2012 Minutes

However, in January, there was an addition to this list of costs:

However, many participants also expressed some concerns about potential costs and risks arising from further asset purchases. Several participants discussed the possible complications that additional purchases could cause for the eventual withdrawal of policy accommodation, a few mentioned the prospect of inflationary risks, and some noted that further asset purchases could foster market behavior that could undermine financial stability.

Source: FOMC Jan 2013 Minutes

In March:

Participants pointed to possible risks to the stability of the financial system, the functioning of particular financial markets, the smooth withdrawal of monetary accommodation when it eventually becomes appropriate, and the Federal Reserve's net income.

Source: FOMC March 2013 Minutes

Note how risks to the financial system went from last to first in the March minutes. As the minutes go on to elaborate:

Asset purchases were seen by some as having a potential to contribute to imbalances in financial markets and asset prices, which could undermine financial stability over time. Moreover, to the extent that asset purchases push down longer-term interest rates, they potentially expose financial markets to a rapid rise in those rates in the future, which could impose significant losses on some investors and intermediaries.

Source: Same as above.

Treasury yields were testing 2% in early March already. Due to a brief spell of poor economic data in April and uncertainty from Cyprus, Fed officials toned down their cost-benefit talk and FOMC minutes for April barely mentioned the words "cost" and "benefit". 10 year US Treasury yields hit the low for the year. However, financial stability got more spotlight:

A few participants expressed concern that conditions in certain U.S. financial markets were becoming too buoyant, pointing to the elevated issuance of bonds by lower-credit-quality firms or of bonds with fewer restrictions on collateral and payment terms...One participant cautioned that the emergence of financial imbalances could prove difficult for regulators to identify and address, and that it would be appropriate to adjust monetary policy to help guard against risks to financial stability.

Source: FOMC April 2013 Minutes

Summary: Risks to financial stability from keeping rates at a low level have drawn increasing attention from the Fed and are the #1 worry when it comes to the costs of QE.

2) What do other participants say?

PIMCO's Bill Gross (paraphrased): Lower deficits in Washington mean the Treasury will issue less debt, which could create a shortage of Treasury securities if the Fed continues QE at its current pace.

Greenspan: Taper regardless of economy, Bond prices have got to fall. Long-term rates have got to rise:

There is a general presumption that we can wait indefinitely and make judgments on when we're going to move. I'm not sure the market will allow us to do that.

More importantly, minutes of the Federal Advisory Council meeting (in short, the Fed and representative banks from 12 Fed districts) held in May show that the financial sector is deeply worried over certain consequences of QE. Starting page 14, when asked to assess monetary policy, 2 paragraphs pay lip service to confirming the correctness of QE while 4 long paragraphs cast doubt on its effectiveness and risks.

3) Do the jobs numbers matter?

Source: BLS A-15. Alternative measures of labor underutilization

While the labor market has improved, it is still far from normal. U-6, the broadest indicator of unemployment that includes underemployment, is at a staggering 14%. Even if we view the 10% level of of 2003 (and 1995, not included chart) as "the new normal", that's still 4% or 6 million jobs away. If we're aiming for a U-6 of 8% (which is where it pretty much was in the late 90s and mid 00s), then that's 6% or 9 million jobs away. Though the Fed might pay more attention to the headline unemployment number, if the economy is really in a better shape, then the U-6 unemployed should trickle down into the U-3 unemployed. In this context, the speculation over whether non-farm payrolls are 130k or 190k, whether 3 months of 200k NFPs make it likely for a Fed September taper seem rather irrelevant. It'll take average monthly job creation of 200K for 45 months (almost 4 years) to get U-6 back down to 8%.

Fed officials still talk in the unemployment/inflation paradigm perhaps because this gives them wiggle room in case economic conditions deteriorate for whatever reason and they need to extend existing accommodative programs. This is just constructive ambiguity, and these factors may not be at the top of their list.

4) Conclusion

My interpretation of the Fed minutes and other data is that financial stability risks from an extended low rate environment are the main reasons the Fed is considering an exit strategy. If unemployment was really the focus, then labor market conditions are far from warranting a Qexit, especially when it's uncertain how well the job market will do gong forward. With this in mind, it appears likely the Fed will taper in the future regardless of what they're saying to soothe the markets now or what economic data looks like* (*:As long as it isn't totally horrible).

While the Fed has been striving to soothe the markets in the past few weeks, it is imperative, especially for bond investors TLT (NYSEARCA:TLT), HYG (NYSEARCA:HYG), to remain vigilant. The Fed's withdrawing liquidity will also probably precipitate a crisis in weak emerging market currencies (South African Rand etc) and stocks EEM (NYSEARCA:EEM) as yours truly has been banging on about for a while.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.I may short South African Rand etc when I feel the time is right. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.