The Fed Is Not Going Away

Wow.  That about describes what the Fed decided when it announced it was not going to scale back asset purchases.  We thought for sure the Fed was going to cut back its stimulus.  This was the best chance for the Fed to begin exiting asset purchases while transitioning to a new Fed Chief in January.  It is very clear now that the Fed is likely never exiting; it is never cutting back on stimulus. 

The Fed has just put itself in a box that it isn’t going to be able to get out of.  Printing money and purchasing assets leads to lower rates and helps to re-inflate the real estate market.  At the same time, these low rates also help keep the government's borrowing costs low at a time when it's running huge deficits.

Did you know that despite the national debt being nearly triple what it was in the mid-1990’s, the nominal interest payments are actually about the same as they are today? This means that despite the far higher national debt, the government pays about the same amount as interest on this debt as it did 20 years ago.  Instead of paying 3% and 7% on 1-year and 10-year Treasury bonds for example, the government is currently paying about 0.25% and 2.75%. Keeping interest rates low is not necessarily just about benefiting the economy (although that is the intent), but rather about keeping the government itself solvent in a time of major political and fiscal problems.

With the Fed announcement this week, the markets broke out to new all-time highs.  While the Fed will never publically admit, part of the reason they decided not to taper is the Fed is fearful of what it would do to the equity markets.  The Fed has been involved in the capital markets now for over 5 years and counting.  The economy, as well as the stock and bond markets, is relying on this stimulus.  If the Fed stops providing stimulus it could cause another crisis, at least that’s what they probably believe.

Now the next Fed meeting isn’t until December.  At that time, Bernanke will be just a few short weeks from stepping down.  We should also know who the new Fed chief will be in the next month.  After the December meeting the next meeting is in March, and the new Fed chair will be barely two months into the job. We don’t expect any changes to policy until at least that time. 

The Fed is going to continue to print until it is forced to stop.  Unfortunately they don’t even know when that will be.  The Feds actions are likely going to create other issues yet to be determined.  The eventual comeuppance will not be pretty, but it’s impossible to know when it will occur.  As with most things in life, timing is everything.   

Why The Fed Will Taper

If you think the Federal Reserve has been happy with the rapid rise in Treasury yields, particularly the 10 year yield, you would be mistaken.  The Fed has to be very uncomfortable with the velocity of this recent move, which has seen the 10 year yield climb up from 1.6 percent to 2.9 percent in just 3 short months.  So how does the Fed keep the 10 year yield from climbing even higher, even as their policies are being questioned?  The Fed tapers asset purchases.

The central bank likely believes that is creating a number of possible asset bubbles that will only get worse if the Fed continues down the current path.  The Fed is probably becoming fearful that any further increase in speculative driven behavior could threaten the financial stability of the U.S. banking system in the future.  Tapering will show the markets the Fed is very serious about creating price stability and is working to return capital markets to normal function.

However, tapering could rattle the markets as it comes at a time when economic data has been mixed to slightly weaker than expected.  Rattled markets would likely mean a flight to safely (treasuries) which could push down the 10 year yield.  In this scenario the Fed gets everything they want – lower interest rates, less asset purchases each month, and less liquidity flowing into the stock market.  Can someone say Goldilocks?