When Will Tapering Begin?

September 28, 2013
By Vlad Karpel

The debate about the direction that monetary policy is about to take has been on the table for months. In fact, the tapering issue has been prominent since Ben Bernanke publicly stated that the FED would start cutting on the current asset purchase program, effective this year..The purpose of cutting this program is to completely end it by mid-2014. His comments were a deception for financial markets. The low bond yields and interest rates had been a key driver for stock prices for the past several years. Simultaneously, announcing a cut on such a supportive program could also mean that the FED had an improved view about the economy. If this were the case, it would had been taken as positive for the interests of corporate America. However, that wasn’t the case. Instead, stocks saw volatility increase and experienced large declines.

To put an end to the blood bath, Bernanke and a few of FED’s Presidents had to rescue markets with reworded statements and dovish comments. In a game of words, tapering expectations were pushed forward to September and the FED was expected to cut just $10-$15 billion on its monthly asset purchases. This silenced markets for a while, restoring investors’ confidence.

But investors’ expectations were crushed once again last week when the FED decided to leave its current policy unchanged. It caught everyone off-guard. Bond yields dropped again, stocks rose, and gold also rose. At first sight, it was a positive surprise, but one that puts the credibility of the central bank at odds and gives us a signal that there are some persistent problems that will take time to be solved.

But, was that really unexpected? When will tapering occur?

The FED seems concerned with what could happen to the US economy if tapering occurs. With unemployment taking years to recover just halfway back to what it was before the crisis while growth is creeping at sluggish rates, Bernanke probably believes the economy would be thrown into the abyss as soon as the FED tightens its policy. Look at the latest economic data coming from the job market, for example. Non-farm payrolls grew 169,000 in August and 162,000 in July. This is much less than the usual 200,000 that has been commonly agreed upon as being necessary for real job creation. The unemployment rate sits at 7.3%, which is still too high for a healthy economy.

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The FED has other concerns as well. The main worry is the bond market. Specifically, the ability for the federal government to finance its huge debt load at very low prices. In his statement, Bernanke referred to the tightening of financial conditions as one of the reasons to keep the policy as is. The catch here is, if the economy was really on track, it wouldn’t be a 3% 10-year rate that would derail it. That could hardly be considered as a problem. Unless there are other things going on behind…

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The US government currently holds a huge debt pile. It amounts to 105% of GDP and will soon have to renegotiate an increase on the debt ceiling to avoid a default. As soon as the FED stops buying government debt, interest rates will dramatically increase and the government will press the central bank to continue buying debt. There are only two options available: reduce government debt through the adoption of an austerity package (as in peripheral Europe), or let inflation roll and alleviate government debt.

You already know what the decision will be. What can’t be known is the dimension of it. The best thing to do is to prepare a portfolio of stocks that do particularly well within inflation environments. Value stocks, which have stronger cash flows, are preferred over growth stocks, and precious metals are always a good hedge against inflation.

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