The Taper Is Here To Stay

by: Calafia Beach Pundit

Good news today from the FOMC: they will continue to taper their purchases of bonds by $10 billion per month. At this pace the Fed would stop buying bonds by October, although they might continue to reinvest coupons and maturing principal for awhile longer. It's nice that the Fed was undeterred by the recent flareup in emerging markets or by the unexpected weakness in December job gains. It's also nice that markets have not displayed any unusual amount of anxiety over what is now an important and durable course correction in U.S. monetary policy. Over time, this should contribute to a further, gradual increase in confidence and a further, gradual decline in money demand, and as such should give a modest upward boost to nominal GDP.

Two-year swap spreads, shown in the chart above, are excellent and forward-looking indicators of systemic risk. Currently they are about as low as they have ever been, which suggests that markets are highly liquid, confident that the future holds no big surprises, and expecting economic and financial conditions to improve. Swap spreads were unchanged on the FOMC news today.

The Vix index is a good proxy for the market's level of fear, anxiety and general uncertainty. The index rose modestly (shown in the chart above as a decline in the red line) a few days ago as the emerging market turmoil left global markets disconcerted, but this sort of increase in the Vix is relatively minor in the great scheme of things. Indeed, the flareups of unease and fear that we have seen in the past two years have all been relatively minor, compared to the huge bouts of panic that accompanied the financial disasters of late 2008 and the emergence of the Eurozone sovereign debt crisis in 2010 and 2011. Equities typically decline as fear rises, and rise as fears decline. It's likely we'll see a repeat of this sooner or later.

Gold and short-maturity TIPS are classic refuges in times of great uncertainty, and the prices of both have been trading fairly steadily at lower levels over the past six months. (The chart above shows the inverse of TIPS real yields, which is a good proxy for their price.) I take that to mean that the market's demand for safe assets has been relatively unchanged of late, despite the announcement of tapering, and despite the problems in the emerging market space.