- Bond yields may not feel the pressure to rise further and stocks may be able to continue their liquidity-fueled rally.
- The prospect of reducing and eliminating QE3 will eventually resurface.
Much to the market’s surprise, the Fed did not announce at its September FOMC meeting that it would start tapering QE3, i.e., reduce the amount of monthly bond purchases, which currently stand at $85 billion.
The overwhelming consensus had been that, following several months of messaging that a taper was imminent, that the Fed would take a modest step at its September meeting by reducing its purchases by $10 billion-$15 billion. Not enough to put a dent into the recovery, but enough to send the message that the “full-throttle” response was no longer warranted.
Well, so much for consensus. The Fed surprised everyone by doing nothing. As a result, stocks ripped to new all-time highs and bonds staged a strong rally as well, with the 10-year Treasury yield declining below 3% on September 19, the day of the Fed announcement.
So everything is back to normal, right? At the surface it would seem so. With no tapering imminent, bond yields may not have to feel the pressure to rise further and stocks can continue their liquidity-fueled rally. Perhaps the stock market can now get back to the business of focusing on earnings and valuation.
But the prospect of reducing and eliminating QE3 may eventually resurface. Not today, for sure, maybe not next month or even next quarter, but eventually. So, while the markets are relieved, at some point we may have to go down this road again.
Why no taper?
So why did the Fed back off its plan to taper QE3? My sense is that just the talk of tapering back in May and June created such an adverse response in the financial markets that it now poses a threat to the real economy. Markets discount and look forward, and just the hint that the era of easy money was ending caused the markets to tighten liquidity conditions, forcing stocks to correct, interest rates to rise, and credit spreads to widen.
That alone was probably not enough to sway the Fed, but it is clear that this tightening of liquidity conditions affected the real economy, and this is likely what has worried the Fed the most. For instance, the sharp rise in the 10-year Treasury yield last spring has caused mortgage rates to shoot up, with the 30-year fixed rate mortgage rate rising from 3.25% to 5%. This has taken a fairly immediate toll on the housing market, as evidenced by the recent sharp decline in mortgage refinancings.
So, the Fed’s mere mention of a taper appears to have done real damage to the more interest-rate sensitive side of the economy, which in turn is preventing the Fed from following through on its intentions. It goes to show that the bond market is generally several steps ahead of the Fed in terms of easing or tightening.
It seems pretty clear to me that the Fed is taking its cue from the markets as to whether it can proceed with tapering or not, or at least from the market’s impact on the real economy. It shows just how powerful the bond market is in affecting economic activity and, by extension, how much say the markets have in monetary policy.
But for now, while the Fed keeps filling the punch bowl, all seems well with the world. But eventually, the Fed will have to bring up this unpleasant topic again, and then we may get to relive the whole experience—all over again.
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