Too Many Obstacles Preventing An Open FED Taper

Includes: SPTL
by: Michael James McDonald

I don't believe the FED can begin tapering in September or even any time soon. In fact, it may actually have to expand the buying program for a short period. The reason for this contrary and very unconventional view ultimately traces back to the open policy of the Bernanke FED.

Prior FEDs were almost always secretive. An open policy can be either positive or negative depending on the action. In its initial stages full disclosure on QE was highly positive. It caused many member banks and dealers to do the same - buy bonds. And why not, it was a near riskless trade - borrowing money at zero percent and then earning 1% to 2% on the bonds - knowing the FED would keep bond prices stable for two years.

This forward buying of allied investors combined with QE3 purchases worked to drive yields even lower, magnifying the overall effect of QE3. The FED purchased over three trillion in notes and mortgage bonds in its effort to keep rates low. While it's very difficult to know how much the allied investors purchased, some evidence points to it being at least two trillion dollars.

So the force that drove the 10-year T-note down to 1.4% last year wasn't just FED buying; it was the combined buying of the FED and all these Allied investors. It's also important to note there wasn't a risk that interest rates would decline too far or too fast; there's not a risk if that happens.

However, the FED must now unwind the program and do it in an orderly way - and it's here where an open policy works against it. Those former investors and allies now become the enemy. When before there was little risk in how low rates declined, there is considerable risk if they rise too fast or too high. The rise in 10-year yields from 1.6% to 2.9% in just three months, was due to a wave of investors selling bonds ahead of a believed September taper. I think the size of the selling startled the FED and highlighted the dilemma.

To maintain the positive benefits of QE, the FED must prevent anymore sudden jumps in interest rates like just occurred. Therefore it must first stabilize rates in a tight range, neutralizing (buying) against any heavy selling in the marketplace counter to this goal.

The only practical way to do this is to stop being so open and continue being vague on its intentions. After watching the rise in rates I think it knows this too. This will allow the flexibility to expand buying, if needed, to purchase the positions of liquidating investors. I believe only when that's accomplished can the FED honestly announce a taper and that could be up to six to 12 months away.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.