Will Bernanke walk the taper talk?

The market has certainly been jolted by all this talk of a tapering, or even an end, to the Fed’s policy of quantitative easing.

Indeed, since speculation about a tapering picked up a couple of months ago, we’ve seen some dramatic moves in US bond yields, which are up 75 basis points since early May (see chart 1). This is the biggest lift in roughly three years and brings the 10-year yield to the highest point since March 2012.

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Now these moves aren’t necessarily without cause. Jobs growth in the US has been strong, as has private demand growth. Fed presidents have openly discussed a tapering for months and chairman Ben Bernanke, in latest press conference, said that: “If the incoming data are broadly consistent [with their forecasts], the committee currently anticipates that it would be appropriate to moderate the pace of purchases later this year. If the subsequent data remain broadly aligned with our current expectations for the economy, we will continue to reduce the pace of purchases in measured steps through the first-half of next year, ending purchases around mid-year”. You can see the Fed’s forecasts below in table 1.

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Noting these, there were some nuances in Bernanke’s press conference that made me think the Fed isn’t as close to a tapering as the market thinks and as the Fed is allowing people to believe.

For a start, one key voter on the committee, James Bullard, actually dissented and wanted the Fed to articulate a stronger message about defending against low inflation. This is important because, by consensus, the Fed members actually downgraded their inflation forecasts for both this year (sharply) and next, as you can see in table 1.

Indeed, Bernanke outlined in his press conference what he thought would be the threshold for QE to end next year, and it’s safe to say we’re not near that yet. He wants to see ‘solid’ economic growth, and an unemployment rate in the vicinity of 7%, and inflation (as measured by the core PCE) back toward 2%. You’ll note from table 1 that the central forecast is for inflation to be just below 2% at the end of next year, with 1.5% the bottom of that range.

Fair to say that the Fed does forecast the unemployment rate, under a good scenario, to be in the vicinity of 7% mid next year by the looks, with a year-end forecast unemployment rate of 6.8% at the upper bound. Even then, however, there is another caveat that Bernanke has made. Bernanke is of the view that the decline in the unemployment rate actually reflects, in part at least, still weak demand conditions and he points to lower participation rates than the US is used to, and a high under-utilisation rate to back his point. This is a very subtle nuance, but it’s extremely important because Bernanke explained that the 6.5% or 7% unemployment rates cited to ease off on QE are only thresholds, not targets, and cannot be viewed in isolation. It’s fair to assume then that the Fed would want to see the participation rate lift in tandem with any decline in the unemployment rate – we’re not really seeing this as yet, and indeed it’s still trending down.  

Don’t forget also that the Fed’s budget problems haven’t really been solved. They’re in a much stronger position than they were last year, thanks to strong revenue growth. Nevertheless, budget projections from the Congressional Budget Office still show the rapid improvement in the budget deficit (chart 2 below) relies on quite strong growth forecasts and an assumption of a 10-year bond rate not too much higher than now for the next year or two. This becomes a bit more challenging in the event that QE ends and the US actually has to tap the market rather than the Fed for funds.

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Now, in relation to that, my read of Bernanke’s press conference was that the Fed is already a little ‘puzzled’, read concerned, by the moves in bond yields that we’ve seen already – and they haven’t even tapered yet! Bernanke noted the moves were not consistent with the fact that the balance sheet or assets held by the Fed were still growing. Indeed, Bernanke noted that even if the Fed halted QE altogether then the Fed’s balance sheet, or the stock of total assets (bonds held etc) of the Fed would still be huge at around $4 trillion. Now this is important because it is Bernanke’s view that it’s the stock of bonds held that affect long-term rates. Given that the Fed isn’t selling any bonds and indeed would still be adding to them until at least mid next year, the implication is that the Fed isn’t expecting a material lift in bond yields in the event that QE is tapered.

For mine, the recent spike in yields probably shows more than anything why the Fed will find it difficult to completely exit from QE. Moreover, I’m not sure that the US government is even in that much of a rush given the long-term budget problems of an ageing population.

With that in mind, we can’t overlook another caveat discussed by Bernanke.  He noted that if financial conditions (bond yields, short-term market rates, lending rates more broadly, and the exchange rate) were not consistent with where the Fed wanted policy to be – i.e. ultra-loose – then that would impact on the Fed’s decision to taper etc, even if the growth, inflation and employment thresholds were met.   

The key for investors is to watch the press. If noted Fed watchers at the Wall Street Journal and elsewhere write with confidence that QE will be tapered, then it’s best to assume that’s true. The Fed won’t want to shock the market and, going on past behaviours, will flag its intentions well and truly in advance. I’m just not convinced they’ve actually done this as yet, to the extent everyone thinks.

Now, in the event that I’m wrong, I don’t think equity investors should really be alarmed about taking a large QE related hit to their portfolio. For a start, the market is convinced that QE will be tapered as early as October. Yet US stocks so far have barely moved – down 2%-ish from their peak. Sure, the Aussie market might be off 9% from the peak, but this has more to do with the downturn everyone is discussing but no one is forecasting.

The comparative stability of US stocks is based on yet another unspoken caveat. Take a look at chart 3. It shows quite clearly the Bernanke put, or the fact that the Fed is watching the equity market and will act in the event too much risk is taken off the table.

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The Fed is essentially trapped, trying to tame the market and direct market moves in a way that is consistent with the Fed’s policies. This is no easy task and makes it a very volatile ride for investors. With that in mind, I don’t think that it’s very likely that the Fed will be overly aggressive in tapering or even ending QE, especially with all the subtle caveats and exceptions dropped in by chairman Bernanke.