Escape is Impossible

Bernanke taper time
Photo: Bloomberg

Since the end of 2008, the US Federal Reserve has cranked up its monetary easing policies several times to get the US economy growing again. The Fed is like the gambler doubling down on their losing bets, hoping for that next big win which will erase all their losses. The Fed is hoping for that next big win in the form of sustainable job creation of at least 200K new jobs every month and the unemployment rate to fall to 6.5%. Few have asked the question of whether the Fed’s monetary policies even work given the build-up of excess reserves on the balance sheets of banks. Yet here we are, a year on with the most expansionary monetary policy ever and we are debating if the economy is ready for a taper. In economics there is the law of diminishing returns and with the Fed resigned to continually buy bonds, the effects of the purchases has diminished to the point where the Fed has become impotent.

The problem for the Fed and other central banks is that as soon as they set a target for withdrawing stimulus policies, the markets anticipate it months in advance which brings forward the effect on the economy. This is the phenomena of reflexivity that George Soros referred to whereby the economy affects financial markets and importantly, the financial markets affect the economy.

First blood

In the middle of 2013, the yield on the US 10 year bond rose from 1.5% to peak at 3% in just a few months. The rapid increase in rates also affected emerging markets (EMs), which had increased their monetary supply in recent years to offset capital inflows caused by the Fed’s quantitative easing (QE) program. When US yields rose, EM yields followed, and their currencies fell as capital flowed back into the US. This phenomenon caught the entire market with its pants down and highlighted the precarious position central banks had left credit markets in.

This was the market’s canary in the coal mine. Perversely, as capital flowed out of EMs and their currencies depreciated against the US dollar, EM central banks sold their foreign reserves to buy their domestic currencies and slow down the capital outflow. You can read about what happened to India here. If the Fed reduces purchases and foreign CBs are also selling US treasuries as we saw earlier this year, US yields will definitely rise as net supply dramatically increases. The effect of rising long-term rates on the US economy will end the recovery faster than you can say nominal GDP targeting! If EMs let their currencies depreciate, imported energy and food prices will rise and will be devastating to their economies. This is why we should see EMs reducing the reserves to support their currencies.

Everyone knows that the endless purchase of securities is unsustainable because at current projections the Fed will eventually monetise the entire US treasury supply. The problem with this outcome is that US treasuries are utilised to hedge investments and as collateral throughout the financial system. If treasuries become scarcer, liquidity will decline and we will see volatility in short-term rates. This means the Fed will stop ALL treasury purchases at some point. 

The Fed is buying most of the US treasury's supply

Repercussions

Rates will rise but will we see another volatile move or a slow melt? There is the argument that the dramatic move in rates this years was caused by MBS convexity hedging, which you can read about here. The next question is can the US economy handle a 10 year yield above 3% without sending the economy into recession? Or what about a confidence boosting 20-30% decline in the S&P500 as investors rotate from stocks to bonds? I’ll let you ponder that. Just look at how higher rates have affected US mortgage applications which hit a 13 year low to understand how higher rates shake up the economy:

US mortgage applications hit a 13 year low
Chart: Bloomberg

The negative economic impact will worsen as rates creep higher. Keep in mind that even with yesterday’s taper of $10bn, the Fed’s balance sheet continues to grow at $75bn per month:

The tiny taper
Source: Zerohedge

A nice trade to profit from further tapering in 2014 would be a US 2s10s curve steepener (long 2yr and short the 10yr). The spread is about 257bp and we would target a spread of 347bp which is 90bp higher. Use a stop loss of 30bp and exit either when the spread hits 347bp or hits the 200 day moving average (whichever occurs first).

While many speculate on when the Fed will completely exit asset purchases, they ignore the market and economic reaction in anticipation and fail to see the reflexive nature of the Fed’s policy.  The Fed will soon realise the futility of finding an exit, because when tiny steps to reduce purchases and sell their bond holdings causes huge moves in the market… there really is no escape.