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What Are The Fed’s Options?

Posted
9/18/2013 10:16:00 AM
By: Martin Tillier
Referenced Stocks:TLT

Later today, the Federal Reserve, through Chairman Ben Bernanke, will make a much awaited statement. Most people with even a slight interest in the market are aware of this and know that this is the one where Bernanke is expected to talk about “Tapering”. All well and good, but I am fairly sure that a percentage of those people are somewhat unsure as to what this scary “tapering” thing is, or what else may be in the announcement.

Forgive me if you are not one of those people. If you have spent the last few months worrying incessantly about what may happen and have studied the probable steps and their possible effects, then the following will be of little use. (I was tempted to make a comment along the lines of “please get a life”, but then realized I had just described myself, so I’ll hold off on the self-righteous condemnation.)

The first things that should be asked are:

What is QE and what is Tapering? Since the financial crisis, the Federal Reserve has, in three stages, pursued a policy of quantitative easing (QE). This policy involves the Fed buying bonds in the open market. This has two effects.

Firstly, the money to make these purchases comes from the central bank simply crediting the account of the selling institution. It didn’t exist before, so in buying the bonds, the Fed effectively “prints” the money and adds it to the system.

Secondly, a huge buyer of bonds (in the current round of QE, these are Treasury bonds and Mortgage Backed Securities, or MBS) keeps the prices of them high, and therefore the yields (interest rates) low.

The possible harmful, unintended consequences may include inflationary pressure and a weaker currency than would otherwise be the case. In both cases, the problem is one of simple supply and demand. As the supply of dollars is increased, so each one of them has less value, whether that value is expressed in terms of goods and services or other currencies.

 For the above reasons, this policy, while originally stated to be open ended, must come to an end at some time. Tapering is the name given to a gradual reduction, rather than a sudden ending of these purchases.

Next we should address the question:

What Are the Options for the Fed:

The first and most obvious choice they must make is whether to begin tapering now or not. The consensus, with which I agree, is that they will begin this month, and assuming they do, there are a couple of other things that they will need to address.

 Those purchases are currently running at $85 Billion per month, and the Fed will inform us by how much they will cut QE initially.  Estimates as to the extent of the reduction vary, but somewhere around $10-$15 billion looks most likely.

The other thing that they should tell us is where the cuts will be made. The feeling of observers here is that cuts will be made in both Treasury and MBS purchases, in a 60/40 or 70/30 ratio. It wouldn’t surprise me, however if, with a nod to a faltering housing recovery, the initial reduction was 100% in Treasury purchases.

What Else Should We Listen or Look For? Of course, anybody who has ever listened to a Fed press conference knows that Chairman Bernanke will not just give us the basics. He will attempt to explain and justify any decision made.

In that explanation will be an economic outlook. One would assume that tapering will only begin if that outlook is positive, but it may be that the pressure of expectations will lead to a cut in QE, even if the outlook is a little more questionable. In that case, listen out for a suggestion that any cut is subject to economic improvement and could be reversed.

What Will The Effect on Markets Be? In all markets, stocks, bonds, commodities and currencies, some of the expected moves by the Fed have been priced in. This is most evident in longer term Treasury bonds.

The above is a one year chart for the iShares Barclays 20 Year Bond Fund ETF (TLT) which tracks the price of long term treasuries. As you can see, the market knows a reduction is coming some time and has already adjusted. The same is true of stocks, but the effect is less obvious. The stock market has continued to rise in the last few months, but the rate of increase has been held back by concerns about the end of QE.

This may lead to a degree of “sell the rumor, buy the fact” in the days following the announcement. It certainly means that the down side, should the Fed do as expected, is somewhat limited whereas, should Bernanke surprise the market in some way, there will be little resistance to the upside.

Conclusion:

The initial reaction is probably best ignored by most investors. Even if things happen exactly as predicted, then an initial period of volatility is to be expected, but the real reaction will only become clear in the following days. Because, as I explained, I believe that an upward move in both Treasury and stock prices is likely, I think any initial drop is likely to be short lived unless the amount of reduction is more than expected. A Pull-back in stock prices will represent a buying opportunity for those with cash on the sidelines. For those who are fully invested and have a long term view, “wait and see” is, as usual, the best advice.

The media, of which I guess I am a part, has a vested interest in making all things sound like end of the world occurrences, but should tapering actually come today, the effects may well not be as dramatic as many fear. In any event, you hopefully now have a better understanding of what the Fed’s options are. Happy viewing!