Thursday, December 5, 2013

A "Taper" In a Teapot?

Stephen Antczak of Citigroup is out with an interesting research piece this morning on tapering.

Market participants have been worried for most of the year about what will happen when the Fed gradually starts withdrawing (i.e.,"tapering") its active in the credit markets.

In June of this year, for example, interest rates jumped higher, and the stock market moved lower, when Fed Chair Bernanke suggested that the Fed might start gradually reducing its bond buying program.  Although Bernanke later claimed that his remarks were misinterpreted, many investors viewed the negative market reaction in June as a harbinger of things to come.

Antczak gives three reasons that Citi believe that fears over tapering are overblown:
  1. Net Treasury issuance in 2014 is projected to be at its lowest level since 2008 as the federal deficit gradually declines.  Meanwhile, $1.4 trillion in Treasury debt is set to mature next year, and it is likely that a large chunk of these funds will be plowed back into the government bond market;
  2. The amount of attention to tapering has dramatically increased in recent months.  Citi's research indicates that nearly 300 stories a day have been written on the market effect of tapering compared to almost none at the beginning of the year.  With so much attention being paid to the issue, perhaps market prices already reflect the beginning of tapering;
  3. Following on point 2, Citi looked back at prior periods when interest rates on Treasury debt moved sharply higher. They found that corporate bond yields did not move up nearly as much as Treasury yields, meaning that the net effect of a rise in government interest rates would not be felt as much by corporate bond investors even if rates rise when the Fed begins to taper.
 The more I study this issue, the more I am inclined to agree with Citi.  Perhaps the initial reaction to a Fed tapering announcement might be negative, but the Fed will probably not move until the economy shows solid signs of improvement. 

In other words, if the Fed is beginning to leave the credit markets, corporate America is probably chugging along with enough steam to generate earnings growth that will support current market levels.

For your reference, I last wrote about tapering at the end of October 2013. I referenced an interview with Nobel laureate Eugene Fama who also believed that tapering will essentially be a non-issue.  Here is an excerpt from my Random Glenings piece dated October 30, 2013, with the link below:

Nobel Prize winner Eugene Fama was interviewed by CNBC's Rick Santelli earlier this week.
In his usual hysterical fashion, Santelli was trying to get Fama to say that interest rates were set to soar once the Fed ends its "Quantitative Easing" (QE) program.

Problem was, Fama doesn't believe it.

As you will see from the interview, Fama notes that he has been doing research on the possible effects on the credit markets once the Fed starts reducing its holdings of longer term Treasurys.

Fama doesn't believe the markets will be as roiled as Wall Street believes once the Fed stops buying.

He points out that the purchases of Treasurys have been financed by the Fed's borrowing activities in the short term market.  Thus, the $4 trillion in Treasurys that it holds have been financed by $4 trillion in borrowing.  Reducing one side of the ledger also reduces the other side, so the net effect should be relatively neutral.