Comstock Partners, Inc.September 19, 2013
The Fed's Decision Reflects Its Great Concern About The Economy
The Fed’s surprising decision to postpone any tapering is a result of its own blunder. It misread the impact of its May decision to begin discussing the strong possibility of reducing bond purchases in a few months. It subsequently compounded the error through press conferences, congressional testimony and numerous speeches. Both Chairman Bernanke and various Fed governors strongly hinted at imminent tapering until very recently.
Fed officials heavily influenced investor expectations to a point where the overwhelming majority of “the street” expected at least a minimal reduction in bond purchases at the September meeting. The Fed, through its numerous spokesmen, allowed, and, yes, encouraged this consensus to form with little attempt to walk it back.
The FOMC stated in its press release that “the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market.” By “tightening”, they are obviously referring to the quick 140 basis point jump in the 10-year bond yield. What they don’t mention is that the soaring yield was a direct result of the discussion of tapering by the Fed itself. This threatened to slow down an already fragile economy and put a damper on the housing market.
The Fed realized almost immediately that it had blundered in discussing tapering in May. They tried to walk it back by emphasizing how, despite cutting back bond purchases, they would still be expanding the Fed’s balance sheet and that the tapering would not change the fed funds policy of keeping rates near zero for as long as necessary. However, once investors were convinced that quantitative easing was no longer open-ended, 10-year yields continued to hover near their peak, thereby threatening future economic growth.
In our view, the failure of the economy to embark on a more self-sustaining growth path was also an important factor in delaying any tapering, although the Fed has consistently pointed to “underlying strength in the broad economy”. This is contradicted by the Fed’s own forecast, which reduced projected GDP growth in both 2013 and 2014. In fact, the Fed’s initial forecast of 2013 GDP growth, made in the 1st quarter of 2011, has been steadily reduced to a point where it is now about 50% below where it started. Even when the FOMC first began talking about tapering a few months ago it knew how sluggish economic growth had been, but relied upon another flawed forecast of a 2nd half rebound. As early as July 18th, we wrote a comment titled “The FOMC’s 2013 Is Already Obsolete----On The High Side”.
In addition, Bernanke, at his press conference following the FOMC meeting, mentioned the uncertainty of the outcome of the clash in Washington over the continuing budget resolution and the debt ceiling limit. This is certainly understandable, but is something the FOMC has known about for a long time.
We have consistently believed that economic growth remained weak, and did not by itself justify a tapering of QE. Although there are many doubts about whether QE actually enhances economic growth, and there could be future problems in winding down the Fed’s balance sheet, the Fed has consistently justified QE almost exclusively in terms of economic growth, particularly unemployment. On these terms alone, the proposed reduction of QE did not meet the Fed’s test, and is not likely to in the months ahead. Significantly, Bernanke, at his press conference, no longer sounded confident about starting to taper by year-end.
In sum, the Fed’s decision not to taper was based on the sudden steep rise in bond yields and economic weakness that will impact corporate earnings. However, the start of tapering will always be a subject of discussion at the next FOMC meeting, and they come up pretty often. With tapering always possible within six weeks, any decline in bond yields and mortgage rates will probably be minimal. Investors will now zero in on the fight over the continuing budget resolution and the debt limit ceiling, and right now that looks really scary with good reason. When two sides are adamant in calling each other’s bluff, going off the cliff is always possible. In our view, therefore, the stock market’s move to new highs will likely be a false breakout.