Federal Reserve Chairman Ben Bernanke announced Wednesday it will begin tapering asset purchases next month. Source: Alex Wong/Getty Images.
The S&P 500 hit another new closing high Wednesday (ordinarily, not something we’d note with fanfare, considering how many new highs markets hit during the average bull) but Wednesday was no ordinary day. It was a taper day! Yes, the Fed finally announced it will slow the pace of monthly bond purchases—the announcement many investors have dreaded for the past seven months. Yet markets didn’t throw a taper tantrum—they jumped! And naturally, headlines scrambled to explain why, searching for positives in the Fed’s statement. In our view though, it’s all just noise. The explanation for markets’ alleged reaction seems simple: Forward-looking markets already dealt with it. Boring as this may seem, the Fed’s move shouldn’t wield significant market impact looking forward. It’s a step in the right direction toward quantitative easing’s (QE) ultimate end, but it’s too incremental to move the yield curve spread much.
Per the Fed’s statement, monthly asset purchases will drop from $85 billion to $75 billion beginning in January. Mortgage-backed security purchases will drop from $40 billion to $35 billion, and long-term Treasury buys from $45 billion to $40 billion. Given how much folks feared even the tiniest taper, headlines reached for anything to explain the market’s apparent acceptance, and they split into two primary camps.
One claimed markets did fine because it was a “dovish taper”—a small reduction paired with a pledge to keep short rates near zero for longer than initially outlined and assurances from Ben Bernanke the recovery was “far from complete.” The other claimed markets interpreted the Fed’s decision as a vote of confidence in the economy. Which would be nice, but it doesn’t seem to match reality if you consider the aforementioned jawboning and the Fed’s statement. The announcement didn’t signal a big increase in confidence. A few welcome stylistic changes aside—the prose got less wordy!—the language about the economy was about the same as previous months. “Household spending and business fixed investment advanced, while the recovery in the housing sector slowed in recent months.” The only real change was verbiage regarding fiscal policy. They still say, “fiscal policy is restraining growth,” but they noted, “the extent of restraint may be diminishing.” In other words, you can thank Representative Paul Ryan and Senator Patty Murray for the taper.
In our view, this seems a big reason why markets didn’t much fuss after the Fed’s midday release. Almost as soon as Ryan and Murray’s budget deal took shape, headlines started speculating over the compromise’s impact on Fed policy. The Fed has long intimated reduced budget uncertainty and smaller spending cuts were taper criteria, and when news broke Congress was nearing a two-year budget that eases some sequester cuts and raises discretionary spending by $48 billion in fiscal 2014, most assumed a taper was nigh. And as speculation swirled, markets pulled back. Not that you can ever pin short-term volatility on any one thing, but it seems a logical continuation of the volatility coinciding with taper rumors and assumptions since May. Perhaps markets rose Wednesday simply because they already got the drop out of the way—just as they’ve been dealing with the taper’s eventuality since Bernanke first spoke of slowing QE.
Whatever the reason, in our view, there is likely nothing fundamental in Wednesday’s rally—it seemed mostly noise and sentiment, like all short-term moves. Nor is this tiny taper a whopping positive looking forward. Much as we welcome QE’s end, this is only a small step toward that—Bernanke probably trims his beard by a greater percentage every week. A $10 billion decrease to an $85 billion program likely doesn’t do much for long-term yields—especially not after they’ve risen 1.15 percentage points since April 30. $75 billion in monthly purchases is still a weight. As we’ve written before, this hinders bank lending and growth. The spread between long and short rates represents banks’ lending margins—they borrow at short rates and lend at long rates. A small spread means smaller profits, which discourages lending. That dampens money supply growth, robbing the economy of fuel. The sooner the Fed stops, the better.
The Fed’s announcement does accomplish one thing, however: It defines “taper” for the world. No one knew till now! They knew it was a reduction in bond buying, but they didn’t know the magnitude or timing. The Fed’s jawboning gave no hints. The only thing folks knew (or assumed they did) was the taper was bad. But Wednesday, they got some clarity. Not that future tapering must be similarly gradual—and we certainly hope it isn’t! But, at least for now, folks have context—some factual basis for gaming the Fed’s next move. And seeing markets not freak out after taper 1.0 might shore up certainty that much more. We still might see more taper jitters in the future, but the notion of tapering as an automatic volatility trigger seems done.