Saturday, June 22, 2013

To Taper or not to taper, that is the question

Federal Reserve officials are currently trying to figure out whether it is appropriate to reduce the quantitative easing program that began last September (nicknamed QE3). In the meantime, financial markets are fluctuating up and down trying to guess when will the Fed actually taper QE. While some primary dealers (those who trade directly with the Fed) estimate that the Fed will reduce the size of its program by $20 billion as early as the September meeting, consensus is at the October meeting.

In my opinion, it looks like markets may have gotten ahead of itself by pricing in an earlier timing of tapering than would be appropriate given current economic releases. I have no doubt that the Fed will taper but the pace/timing may be slower/later than what markets are currently pricing. Investors must remember that the Fed must comply to its dual mandate of maximum employment and price stability. Let's take a look at recent economic data to see if both criteria merit immediate reduction of QE.

Data on employment:
  • Latest May nonfarm payrolls report came in at 175K, below the 200K run-rate most Fed officials would consider appropriate for an economic recovery
  • The 6 month moving average improved slightly from 150K in August 2012 (pre-QE3) to 196K currently, but even this average is below the 200K mark
  • The labour force participation have dropped to near record lows at 63.3%, far below the 66.0% seen in 2007. This is definitely not a sign of "substantial" improvement of labour markets
Data on prices:
  • Latest reading on core PCE (Fed's preferred measure of inflation) stand at a measly 1.1% year-over-year (y/y), far below the informal 2% inflation target adopted in January 2012. The headline PCE is even worse at 0.7% y/y
  • Latest reading on CPI shows benign inflation with the headline inflation running at 1.1% y/y and core inflation (ex-food and energy) at 1.7% y/y
  • Looking at the breakevens (nominal yields minus real yields as indicated by TIPS), long term inflation expectations reminds stable near 2.2%, far below the 2.8% priced by the market when QE 3 started in September 2012

Hence, looking at the data points above, investors must acknowledge that the economy is gradually improving but a September or even October tapering may be premature. William Dudley of the New York Fed hinted in a speech that the Fed needs at least 4 month of healthy data to consider a  reduction of monetary stimulus. Given that the April-May economic releases are not 100% "healthy", it is likely the Fed will reduce the size of QE3 later than what consensus is currently calling for.

The markets were spooked by the follow statement in the May meeting minutes: " A number of participantsexpressed willingness to adjust the flow of purchases downward as early as the June meeting IF[emphasis added]  the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, VIEWS DIFFFERED [emphasis added] about what evidence would be necessary and the likelihood of that outcome"

Apparently investors only paid attention to the "willingness to adjust flow of purchases as early as the June meeting" instead of "if the economic information received by that time showed evidence of SUFFICENTLY STRONG AND SUSTAINED GROWTH". Also take note that "views differed" so it is likely the committee as a whole may agree on a later date than currently priced in by the market.

Impact on Fixed Income Markets:
Bond markets, which are forward looking in nature, have responded to a possibility of reduced stimulus. The 10-year treasury yield rose over 40bps to 2.29% in the past month while corporate spreads have widen slightly. It is likely that bond markets overreacted to tapering and yields move down in the short term while still gradually increase over the next 1-2 years.

Impact on Equity Markets:
Defensive stocks, which led the rally through the end of April, are likely remain under pressure. Not only due to concerns about tapering but due to rich valuations after gaining over 10% YTD. Cyclical stocks may outperform in the second half of the year as they lagged in the rally so far this year. There is a risk for a short term pull-back in equities from tapering fears but I think tapering would eventually be healthy for the equity market as a whole (see below).

To remind investors, stocks started one of the greatest bull market rallies after the Fed tightened policy in 1983 (after a dreaded double tip recession in the early 80s). Similarly in 1994 when the Fed shocked the market with a 3% rate hike over 12 month, there was some short term volatility but equities continued to advance until 2000.  

Wait, can tapering actually mean good news?
In a interesting piece by bond guru Bill Gross, he argues that tapering is actually good news to the underlying economy despite causing some short term volatility in the financial markets. The commitment to keeping rates low for an extended period of time is like having a slight deflationary effect on the economy. Why would companies be willing to start investing more now when rates are guaranteed to be low for a long time? Why would a bank increase loans to small businesses when the low interest environment is keeping the yield curve so flat? By giving the message that rates will eventually rise, businesses will have more incentive to lock-in today's low rate and increase underlying business investments. By tapering slowly, monetary policy remains accommodative while at the same time, the private sector is reminded that they better increasing businesses investments or else face higher borrowing costs to do so in the future. For the past few years, the economic recovery is due to a pure wealth effect as the Fed's QE programs pushed up asset prices with little effect on the underlying economy. Perhaps, with the Fed passing on the torch to the private sector, underlying GDP growth can move above the sluggish 2% level.

Investments Strategy going forward:
I want to end this piece with a folksy quote from Buffett: "You don't know who's swimming naked until the tide goes out". Thus, we can't know the full implication of slowing down QE until after the Fed actually taper QE. All the guesses made by market participants are really useless for prudent investment decisions, but it is interesting to note that the speculation of tapering increased volatility in the market, which can be a huge opportunity for those patient investors willing to take advantage of the wild mood of the market. Note that in this piece, I did not guess the exact date when the Fed will taper; rather, I provided facts that the probability of a late-tapering is higher than for an early tapering. Guessing macro variables is not a fun game but always remember that "it is better to be approximately right than precisely wrong".

There is no doubt that there will be continued volatility in the next few month but the increased uncertainty also will create opportunities for shrewd investors.

The piece is for informational purposes only and does not constitute an offer to buy or sell any securities discussed in the report. The author may change his opinion at any time in the future corresponding to new developments and will not be responsible for any capital loss experienced by readers.


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