When in Doubt Blame it on the “Taper”…

You can’t go a day reading financial market news without hearing about the Fed and the “taper”.   The story is generally pretty simple – the Fed is helping to steer stock prices via QE.  And that idea is generally supported by vague charts showing a correlation between the Fed’s balance sheet and the S&P 500.  More recently, this became a story about how the Fed caused a bond market panic.  But earlier this year when discussions about the “taper” began, we started to see markets react oddly.  The bond market sold off as the year progressed and the stock market just continued to shoot higher.  This doesn’t mesh with the conspiracy theories about the Fed and stock prices.  After all, if the rise in bond yields were due  entirely to the “taper” then wouldn’t the same negative behavioral dynamics be impacting stock prices to some degree?  But we haven’t seen any impact of the “taper” on equities.  In fact, equities just continued to surge higher through all this discussion of the taper.

So what is the explanation?  How come bond yields have risen while stock prices have risen?  Well, in my opinion, this is just another case of the fear trade losing out.  The market is really an expectations game.  If most people expect the economy and stock market to perform mediocre and it does slightly better than mediocre then you get a year like 2013 where stocks melt higher as things look better than expected.  The rise in yields is also completely in-line with this thinking.  That is, bond traders who expected yields of 1.6% to sustain themselves in an environment with 2% inflation have been wrong.

I think some people have a tendency to try too hard to attach every little move in the market to some specific policy.  And the Fed and the “taper” is always an easy explanation that makes sense.  But when you look at the performance of stocks and bonds in 2013 this story starts to look a lot less convincing.



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Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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  1. Not quite. When the taper was announced, the market came down hard. Bernanke immediately came out and said: “I didn’t really mean it!” Up and away!!! Message delivered.

    On the other hand, the bond market was caught flat footed by the idea that there would ever be a taper anytime prior to infinity and beyond. The attitude was different. Time to get ready for what might happen and bonds were sold to reduce risk.

  2. My general thoughts on “vague charts”, QE, and tapering:

    I think we need to be very careful when we make charts that show supposed correlations. Event studies are hard to do. All sorts of other unseen events might transpose themselves between the event and the reaction you are trying to measure. A given event may already have burned its effect into prices if it was pre-anticipated. It would be wrong to say that such an event didn’t have an effect on market prices based on the market’s non-reaction to the actual announcement.

    In general, I think the first 45 or so seconds of the S&P’s reaction to *surprising* Fed news is all we should be charting. Which would rule out this chart.

    The “no taper” was a good example of legitimate charting since the news caught most commentators unaware, as revealed by surveys. Nanex captured the immediate reaction quite well with these two charts.

    The market’s reaction to Fed announcements has been hard to measure since it has been difficult to determine if it was QE or forward guidance having an effect. With “no taper”, we’re getting a fairly clear signal of the effect of QE on markets without the distorting effect of forward guidance.

  3. The movement in bond rates had nothing to do with “flow or stock” and everything to do with discounting the inflation premium. When QE3 was implemented Bernanke said he would target inflation and actually put a calendar date on expectations of 2015 to reach his target — a dream scenario for leveraged players in the bond market. Stability of rates promised by the Fed chief is a big deal when placing big bets.

    When the Fed got cold feet and said they were worried about the unintended consequences of QE3 (i.e. the huge leverage in the bond market) and thus changed the parameters to “Forward Guidance” it caused chaos in a market that was long on stable interest rates. Bonds began to finally find true price discovery once “tapering was a possibility” and lo’ and behold the 10 year Treasury note moved very close to it’s 5 year mean of 2.75%.

    The Eurodollar contracts immediately shot up on the front end due to interest rate ambiguity based on “uncertain economic data” and the long end of the curve flattened because markets are see little to no inflation. Interest rates moving up had absolutely nothing to do with supposed economic improvements (historically true) and now confirmed by Bernanke and the Fed board with their reduced growth forecasts.

    Stocks continued to rise based on low inflation expectations and a multiple compression caused by huge investments in the bond market. The bond market had determined in May that the tailwind of QE could be coming to an end and unwound huge investments. BAML has shown that hedge funds and institutional investors (smart money?) have been net sellers of equites for the past number of weeks while retail investors (dumb money?) have finally sold their bonds and have jumped into equities head first. That usually ends well.

  4. Why use the S&P 500? The MSCI ACWI was up a whopping +1.9% on a total return basis from 5/21/13 to 9/17/13 (1st taper talk to no taper surprise).

    Back to the S&P 500. GAAP earnings as of 6/30/2013 are 90.87 per share (please, please, please stop using operating earnings for indices!). That is down from 90.89 1 year ago and up from 84.11 two years ago. Clearly stock prices have increase much more than earnings over the past year. That is, stocks have gotten more expensive. It is also interesting that margins have started to mean revert, ever so slowly.

    I don’t think buying or selling stocks based upon taper talk is any sillier than buying or selling stocks because the economy is improving within a cycle. What percent of the price you paid for a stock comes back to you in dividends and buybacks over the next 2-4 years? Very little.

    In the long-run, nominal stock returns are a function of the following:

    Real sales growth (tracks just under real GDP growth)
    Margins (nil effect in the long run, but has long cycles)
    Changes in valuation

    Dividends are known
    Margins are very mean reverting (this cycle is exceptional and I agree with Cullen that Gov’t deficits contribute to that)
    Real sales growth is something you can get your head around
    Valuation tends to mean revert

    I am taking most of this from GMO. Go find their papers on forecasting 7-year equity returns. It is a great framework and has done well out of sample.

  5. The ACWI is an all world index. QE is a US policy. The Fed doesn’t run monetary policy for the entire world so it makes no sense to use an all world index to understand US monetary policy.

  6. Certainly U.S. monetary policy influences currencies, right? Covered interest rate parity and all.

    Certainly that can influence foreign bond markets as well. Foreign companies can also now borrow more cheaply in dollars, influencing their fundamentals and currency flows.

    Those impacts are real and don’t depend on investor psychology. Your comment is wrong.

    Now it has also been shown that being long carry is a good investment in the long-run (albeit with asymmetrically negative downside). By guiding rates lower with monetary policy, the Fed creates carry in markets, many of them foreign. FX, bonds, and even stocks in some investors minds. Investor psychology has been using the certainty of QE infinity to get long carry in a lot of places, including EM corporate bonds and stocks.

    There are other factors influencing foreign stocks, but an aggressive monetary policy in the largest economy in the world is certainly one significant factor.

  7. I have some friends who think everything in the economy is the Fed, because that is what the media drug they need feeds them. You can’t argue rationally with these people. They are addicted and simple minded. Everything needs a single, simple explanation to people like this. Markets are not single valued or simple. But the media that lives off the drug it feeds them knows it’s profits are tied to the supply of the drug.

    One friend said I have lost touch with reality because I can’t see that everything is the Fed. To back up his position he says “I follow the financial media on TV and internet all day, every day, how can you be so divorced from reality?” I said every time someone says something like that I work up the data myself.

    A recent one passed on from him was that corporate profits are nearly totally dependent on the Fed because the Fed has lowered borrowing costs to corporations through it’s (evil) manipulation of interest rates and this is is 70% or more of their profit gains (true, there are articles in the wacko press claiming this). I said that AAA yields dropped slightly during QE1 (still not to their level 2 mo pre QE1), dropped dramatically after QE1, rose during QE2, dropped dramatically after QE2, and rose during QE3. The net sums are that AAA yields rose 1.3% during QE1-3, and dropped 2.1% in periods between QE1-2, and QE2-3. So for AAA bonds, yields went up during QE and down when QE stopped, but most people are convinced that QE is the Fed artificially suppressing interest rates.

    You can’t deal with these people. They have rejected the basic foundation of Western intelligence. To these people (which based my survey of the news) is 90% of humans, QE has artificially lowered yields. That it’s a provable fact this is exactly wrong doesn’t matter.

    Attributing everything to QE is the drug of those who reject intelligence, which appears to be a vast majority of people.

  8. If 90% of the people believe it and stocks are merely a reflection of expectations, then…

  9. Longer-term bond yields are ultimately a function of short rates, which are in turn a function of Fed policy, which is in turn a function of economic fundamentals.

    So it’s pretty simple. Bond yields have risen because economic expectations have improved. It has nothing to do with QE.

    I believe that is what Cullen is saying.

  10. You need to remember though that if this is the market peak, then stocks are always the last market to notice.

    It is also similar to the commodities and oil rally till mid-2008 although the economy was in recession for 6-7 months. So stocks are the most fashionable (unroken) trend right now as commodities were back then.

  11. The main goal of QE is to create negative interest rates — meaning they are “paying you to borrow” today so you can pay back your loan with a devalued dollar later. The big boys and girls sold debt like crazy to buyback their own stock and send out dividends to the tune of $1.5 trillion in stock buybacks and $1.1 trillion in dividends from 2009 til today. Much easier to push up the price of stocks then actually having to risk capital to produce and sell more goods to customers.

    Everytime QE was started, nominal rates rose as inflation was discounted (nominal rate plus inflation expectations), and subsequently fell everytime QE was stopped because the inflation premium fell.

    Bond yields have gone up because real interest rates (no inflation!) and the cost of money is higher. Hence tapering is tightening.

  12. If QE helped the economy longer term rates should increase. So QE can not depress interest rates unless it creates shortages of long term government bond. If some agents are legally bound to have some of their assets in LTGBs they will bid the price of them up above the price suggested by future short term rates. I do not know if that is the case in the US.

    Also, tapering is gold for the fundamentals of the stock market. All other equal, larger government deficits and larger profits. Probably the market will sell off first, making the opportunity even bigger.

  13. Look at the Yahoo chart of the 10Year:
    Note that JON HILSENRATH was penning articles about this at the WSJ “Fed Maps Exit From Stimulus” (google it it link don’t work).

    a week or so after it has started on it’s perpetual climb higher.
    It seems at least to me that “taper talk” has had an effect on bonds.

    This seems to close to be called a coincidence.

  14. The questions that have always been there:
    1. how does the Fed sell (or not) the purchases?
    2. how does the Fed start to normalized (read RAISE) rates?
    3. what happens when the distressed financial assets get marked to market again?
    4. what if the Fed holds all its paper to maturity? (not sure what that means for some of them, e.g. MBS)

    Another one: Is it legal for the Fed to own some of the paper they have purchased? (I think the answer is “no”).

    Those are the questions, and always have been.

    Again, it’s too early to declare victory. If one can make money on the cyclical bull, great. However, the secular bear may not be over.

    Be careful and good luck.

  15. 1. how does the Fed sell (or not) the purchases?

    They pick up the phone to their friendly dealer and ask for a bid.

    2. how does the Fed start to normalized (read RAISE) rates?

    They wait until the bond market is good and ready. Given that the yield curve is very steep, I’d say the bond market is already somewhat prepared.

    3. what happens when the distressed financial assets get marked to market again?

    You mean like the government guaranteed Treasury bonds and MBS?

    4. what if the Fed holds all its paper to maturity? (not sure what that means for some of them, e.g. MBS)

    The Fed would receive par for its bonds at maturity, just like any other bondholder.

  16. Speculating …
    1. They don’t sell them, unless there are excess deposits in the system, and people want to trade their 0 pct savings for x pct bonds. I guess that would be a hyperinflation, except in my view, T-bonds are 99 pct cash, so what would be the point.
    2. Interesting question: If you have 20T in T-bonds out there, at a normal interest rate of 5 pct, that’s $1T in interest. That would certainly eat into government expenditures. I guess MR would say that you just issue new bonds to pay the interest. MR would probably say that the interest just goes back to the public anyway (you tax Peter and then just pay him back), which is an idea that makes my head explode trying to figure it out. Probably we’d rather not tax the rich and then just give them their money back. Or tax the rich and send the proceeds to China.
    3. That train has left the station. The same answer as No. 1, probably. If the Fed is saying a useless piece of paper is worth par, then it’s an interest-paying dollar. I guess you would buy it based on interest rate. It has value so long as we don’t have hyperinflation.
    4. This is interesting. If the bond matures, Peter’s taxes pay the Fed, which then pays the Treasury, right? This part is confusing. We really don’t have room in the budget to pay the bond unless you could argue that the money would go right back to the Treasury, so then you’d just wash it out and tear up the bond. That is basically my view, which is that when the Fed buys a bond it redeems it. It only stays on the books so we can maintain the accounting ficiton. Or the Fed would try to ‘roll over’ the bond by attracting new deposits, but again, I don’t see where they are going to find all those buyers when they are rolling or issuing trillions every year.

  17. Johnny,

    “This is interesting. If the bond matures, Peter’s taxes pay the Fed, which then pays the Treasury, right?”

    Geoff answered this above your comment, but to sketch it out (I already have in my Example #6), it looks like this prior to the Fed held Tsy bonds maturing:

    A: 0, L: 1 (bonds): E: -1

    A: 1 (bonds), L: 1 (Fed deposits): E: 0

    A: 1 (Fed deposits), L: 1 (deposits): E: 0

    A: 1 (deposits), L: 0: E: 1

    Now the Tsy taxes from the public:

    A: 1 (Fed deposit), L: 1 (bonds): E: 0

    A: 1 (bonds), L: 1 (Fed deposit): E: 0

    A: 0, L: 0: E: 0

    A: 0, L: 0: E: 0

    Now the Tsy pays the principal on the bond:

    A: 0, L: 0: E: 0

    A: 0, L: 0: E: 0

    A: 0, L: 0: E: 0

    A: 0, L: 0: E: 0

    ONLY interest is remitted from the Fed back to the Tsy, not the principal. Payment of the principal is just a simultaneous destruction of assets and liabilities on the Tsy and Fed’s balance sheets, exactly as I’ve illustrated above.

  18. Tom, I can always count on you for the details. Are you sure you weren’t an accountant in a past life?

  19. Thanks Geoff,

    You already covered it with this bit:

    “The Fed would receive par for its bonds at maturity…”

    But I guess Johnny missed that. I could call the above set of balance sheets:

    “How’s that for ‘monetizing’ the debt! You still pay for it in the end!”


    “Hand over your cash! We have to finish ‘monetizing’ the debt!”

  20. I like the second one!

    Seriously, what happens to the Fed bonds when they mature is a very good question that many, many people have asked and continue to ask. Your last sentence is a great answer:

    “Payment of the principal is just a simultaneous destruction of assets and liabilities on the Tsy and Fed’s balance sheets.”

  21. Maybe I’m wrong, but it seems in that example that the public has a deposit (before), but then after the bond matures the public doesn’t have a deposit.
    I think it’s better to accept that a T-bond, like a dollar, doesn’t really have a maturity, except in the sense that when it matures the Fed will exchange you a deposit for the bond, same as they do in QE.
    My understanding of this is based on the idea that a T-bond is 99 percent equal to a dollar or a deposit. Like a dollar, it is a ‘par’ instrument, although the T-bond is redeemed at maturity at par, although there is always a market for them, and the Fed can always make a market. And like a dollar, it can be spent, albeit with the step that you have to sell it — again, never an issue.
    The bond only gets in trouble if the dollar is in trouble.
    The inflationary impact only comes at issuance, if there is any, and there hasn’t been. I used to think that the issued debt was a time bomb, ticking away. But really, QE has convinced me that bonds are pretty similar to any other kind of money — deposit or dollar.
    The real problem, imo, will come if deficits keep accelerating faster than growth, although they do appear to have stalled recently.

  22. Johnny, you write:

    “Maybe I’m wrong, but it seems in that example that the public has a deposit (before), but then after the bond matures the public doesn’t have a deposit.
    I think it’s better to accept that a T-bond, like a dollar, doesn’t really have a maturity, except in the sense that when it matures the Fed will exchange you a deposit for the bond, same as they do in QE.”

    You are right in your 1st sentence there: the public’s deposit was “used” in this case to pay the principal back on the Fed held bond.

    That’s just one way it could have been dealt with. Another, as you know, is that it could be rolled over, with essentially no change in the balance sheets.

    But the T-bond does indeed have a maturity: it’s by no means a sure thing that the Fed will buy it…. and even then, as we’ve seen, it still matures.

  23. The Fed might even sell some of those T-bonds some day (like they did in the decades prior to 2008). In that case would you call it “demonetizing the debt.” :D

  24. Thanks for the answers, but I wasn’t asking about the technical details about how bonds were traded. I was asking about the effects on monetizing and money-printing (= currency debasement).

    I think there are some contradictions here. If QE is not money printing, maybe it’s just a matter of time- it’s just delayed money printing.

    That’s what Hussman has been saying. He says the inflation is coming after 2015. That’s the way I have been thinking too.

    I have some inflation insurance, which has payed off well, but I think you have to wait until a few years from now when they’ll be “required” to do something with the items on the balance sheet.

    It’ll be interesting to see how the phone calls (to sell items) are answered- and profitable to those who know how that goes.

    Either way, I don’t see how the whole exercise (QE) can’t result in monetizing.

  25. So what happens when the Fed sells a bond back to the private sector (should that ever happen again!)… is that “demonetizing?”

    Or how about if Tsy should use tax revenue to pay off a bond? Is that taxing the completing of the “monetizing” exercise? It doesn’t matter who holds the bond: Fed or private sector or SS… Tsy has to raise funds in the TGA to pay the principal: by taxing or rolling over the debt.

    Mike Sproul (a Real Bills Doctrine advocate) would say that when the Fed buys bonds it’s providing “backing” for the liabilities it issues (reserve notes or Fed deposits), and thus the currency holds it’s value. He says the concept of “fiat” money is a myth… that until all channels of “reflux” have been cut off, so-called “fiat” money’s are always backed by “stuff” of real value. I only mention it because it’s an interesting view to me… certainly not orthodox. I have not idea if this is true or not, but it seems to have a slight “Austrian” flavor to me, yet also very different. Mike admits he has a hard time explaining orphaned currencies like the paper money still used in Somalia (years after their central bank was literally destroyed) and a few other cases. You can see him and Nick Rowe “circling each other” in this post:


    If you click on his name you can bring up his “Real Bills” webpage.

  26. The increase in the Fed balance sheet does not offset the decrease in private bank balance sheets from the trend line. The growth rate in bank lending has fallen off the long term trend, and the convolution of this with lower interest rates means that the growth of money in the system is lower than the growth of real productivity. All other things being equal (e.g. flows from overseas) this has to result in lower inflation/deflation.

    The risk we face is deflation. The Fed could write off the entire portfolio of Tsy and we would still be $2-3 T below the money growth rate that produced ca. 3% inflation. It can’t do that, so we are faced with a deflation problem.

  27. There are some long term mega trends in action and there are some smaller short term trends and a lot of ripples. People looking at QE are looking at some meaningless ripples, Cullen on short term trends. Almost no one is putting attention to the long term trends. Good look.

  28. “After all, if the rise in bond yields were due entirely to the “taper” then wouldn’t the same negative behavioral dynamics be impacting stock prices to some degree?”

    Interesting point, nevertheless, the dramatics of “paper taper” effects are more
    compounding on interest bearing related securities…

  29. I think that misses the point. If the Fed sells bonds back to the public, what it’s doing is simply an asset swap — deposits for bonds. Then it carries the deposit on its balance sheet.
    It doesn’t matter what’s on the Fed’s balance sheet, which is unlimited. What matters is what’s in circulation.
    I think the monetization of spending comes when the bond is issued, because it creates a 99-percent dollar-like instrument.
    The Fed *must* backstop the T-bond market.
    I don’t think people accept that. I didn’t until recently, so it’s best that we do, otherwise there will be some nasty shocks in public opinion.
    For example, let’s say that China announces that it wants to redeems it bond holdings for deposits so it can provide expanded health care coverage to its growing population. The Fed conceivably could be forced boy perform a QE-China type operation and ‘buy’ the bonds back for deposits. It would freak out the public unless they are prepared now.

    If tax dollars went to redeem the bonds at maturation, well, that would be big-time deflationary. It would just destroy the tax dollar — AND the NFA. No way you would do that unless you has massive hyperinflation, and even then, how would you do it, make people give away their money?

  30. I suspect deflation is possible because so much of the money that is created these days is not being spent or circulated.
    QE can’t cause inflation because if you take bonds from the wealthy and give them deposits they just exchange it for another financial asset, not a real good.
    Sure, they spend some, but on balance, not as much as if you created money for the working class.
    So what’s the end game — maybe outright wealth confiscation (you have to tax assets, not income in order to reduce wealth inequality), and/or helicopter drops to pay for the coming entitlement bills.

  31. Johnny,

    You might be right about the deflation but nobody is “taking” anything from anyone. Tbond sellers are doing so voluntarily for whatever reason. They don’t know who the buyer is on the other side of the trade. It might be the Fed. It might not.