Starting in late May the Federal Reserve diligently prepared the markets for the dreaded tapering of quantitative easing, based on their assessment of an improving economy. By the time the September meeting of the FOMC (Federal Open Market Committee) occurred, the markets had been thoroughly primed and conventional wisdom considered a $10 – $15 billion a month reduction in the Fed’s current $85 billion/month rate of purchases of Treasuries and MBS a done deal. To put this amount into historical perspective, consider a few pivotal events.
In 1998 Long Term Capital Management (LTCM) was the first organization to receive the Too-Big-To-Fail treatment, requiring a $3.6 billion bailout after losing $4.6 billion in less than four months when the Russian debt crisis threw a massive monkey wrench into its carefully crafted models. At the time I was with JP Morgan with a front row seat to the stock market drama and witnessed the terror running rampant. Conventional wisdom declared loudly that the global financial system would implode unless LTCM was somehow saved. It is interesting to note that the year before LTCM nearly brought global finance to its knees, two members of its Board of Directors, Myron Scholes and Robert Merton, were recipients of the Nobel Prize in Economics. Just for fun, check out the Board of Directors for Dimensional Fund Advisors.
In 2008, Bear Stearns required an infusion of $25 billion from the Federal Reserve to prevent its collapse, an amount that was considered astronomical. This evolved into a $30 billion loan to JP Morgan in order to fund its takeover of Bear to once again, stave off the specter of global financial collapse.
Later on in September of 2008, Lehman went bust without the support Bear had received and global liquidity froze, prompting the TARP bailout package of $787 billion. Ignoring the impact of inflation for simplicity, let’s look at the relative size of the monthly QE program compared to these bailouts.
Current QE program = $85 billion/month
23.6 times the entire bailout for LTCM
2.8 times the one-time loan for Bear Stearns
1.3 times TARP on an annual basis
As the chart at left from the Wall Street Journal illustrates, by September 2/3rds of all economists though it was a done deal. The Fed managed to have the markets fully primed for a reduction in the level of stimulus, and had instilled an increase in uncertainty to somewhat reduce the level of risk-taking, but not enough to cause the markets to get overly skittish. This was the Fed’s master soufflé, cooked to perfection and ready to serve… then Ben sneezed.
The world was stunned to have seen the Fed put in all that hard work to prime the markets, only to have the Fed bow its head with a plaintive, “Just kidding,” at the last moment.
“The Fed shocked markets across the world by leaving its $85bn-a-month asset purchase scheme unchanged on Wednesday, despite guiding traders to believe that so-called “tapering” would begin this month. Most Fed followers had expected the stimulus programme to be reduced by between $5bn and $15bn a month.” UK Daily Telegraph, September 19, 2013
After the Fed’s superb job of convincing most market participants that tapering was a fait accompli, this reversal comes at a high cost.
“This FOMC edition feels less dovish than it does outright scared. Confidence in the outlook has dimmed. That Bernanke had a free pass to begin that tapering process and chose not to follow is telling. The Fed had the market precisely where it needed to be. The delay today has the effect of raising the benchmark to tapering and ultimately makes that first step harder to achieve.” Eric Green, Global Head of Rates, FX and Commodity Research at TD Securities.
“The US Federal Reserve has damaged its credibility and sown confusion about central banks’ communication strategies by surprising markets with its decision to keep quantitative easing on hold, economists have warned.” The UK Daily Telegraph
“Well, as I said in my remarks, I’m a very big believer, the Fed Reserve is a very big believer in transparency and communication. I think transparency in central banking is kind of like truth-telling in everyday life. You got to be consistent about it. You can’t be opportunistic about it.” Federal Reserve Chairman Ben Bernanke in July 11th, 2013 interview with the Wall Street Journal.
The Fed is giving the markets some confusing mixed signals, with Bernanke repeatedly announcing a desire for increased transparency, and for clear communication, and then does this about- face on a reduction that was relatively small in any case, as the chart at right courtesy of ZeroHedge illustrates. The market is now less inclined to believe what the Fed says. Why would the Fed damage its credibility, a valuable asset, over such a trivial change in policy that would arguably have had a negligible impact?
Bear in mind also, according to a recent research report by the San Francisco Fed, all that the Fed has accomplished with its intervention has been a net contribution of 0.13% per year to annual real GDP growth. So what else could it be? If we look to the headlines, the two biggest topics in recovery-talk are getting people back to work and a recovery in housing.
If we delve into the drivers of employment, we see that according to a study by the Kauffman Foundation, between 1996 and 2009 virtually all new jobs come from companies less than five years old. According to the SBA, small firms accounted for 65% of the 15 million net new jobs created between 1993 and 2009. Small businesses produced 46% of private nonfarm GDP in 2008. Small firms are also more intensely innovating. They produce 16.5 times more patents per employee than larger firms. Thus we can easily deduce that new and small businesses are critical to economic growth, but their ranks are dwindling. The level of entrepreneurship in the U.S. is declining. The number of incorporated, self-employed fell from 5.78 million in 2008 to 5.12 million in 2011. The number of unincorporated self-employed declined from 10.59 million in 2006 to 9.45 million in 2011. While incorporated data only go back to 2000, unincorporated self-employed numbers date back decades: the 2011 number was the lowest in a quarter century! The ways to address this depend largely on your economic and political ideology, but there is no denying that small and new businesses depend considerably on personal savings, small loans, and tapping into home equity.
This brings us to the housing recovery. Homes are typically bought using a significant percentage of debt, thus the price of debt, interest rates, will have a material impact on home prices.
The chart at left makes it a bit clearer. The 10 year Treasury yield rose almost 50% in less than 4 months on the tapering talk. That kind of enormous jump in rates cannot help but have an impact on mortgages and financing options for new and small businesses. The Fed has used quantitative easing to artificially lower interest rates, which helps the housing market recover and helps small businesses get moving. If it decreases or stops its bond buying, interest rates rise, the housing recovery stumbles and small businesses have a tougher time getting funding. The hope is that given enough time, the economy will become strong enough under its own steam and no longer need the Fed’s support. The risk is that the economy and the markets will continue to need the Fed’s support indefinitely, meaning it cannot stop its QE programs. Obviously quantitative easing is something that cannot go on forever, and a forceful ending would likely be very painful.
The chart below gives another hint as to what might have the Fed more concerned. Banks have been scaling back their loan portfolio growth rates and now, the year-over-year growth in bank securities holdings is at its lowest level since the financial crisis. While banks are cutting back, the Fed keeps on buying, so much so that now the Fed’s holding of securities exceeds that of all US banks combined! Previously banks owned about 2.5x the Fed’s holdings.
Without being privy to the Fed’s inner communications, we can’t know for certain its rationale behind the tapering delay, but we can deduce that the Fed’s assessment of the potential damage from starting the taper in September was worth the damage to the Fed’s credibility. This warrants careful attention.