The US Federal Reserve minutes show real concern and debate over how big its balance sheet can grow and for how long it can stay that way.
You should share that concern, because a Fed which is buying fewer bonds, or even, heaven forfend, selling some, is a central bank creating, once again, the needed conditions for deflating the bubbles they just blew.
“Several” members of the Federal Open Market Committee argued that they should be prepared to vary the amount of bond purchases, now $ 85 billion per month. “A number,” a form of words meaning less than “several,” said the costs and risks of asset buys might indicate that the Fed should taper or end them before it has reached its avowed employment goal.
Yet another “several” advocated against an early decrease, while “a few” offered the alternative of just pledging to hold on to bonds longer as a kind of palliative or supplement.
Something there for everyone, but the upshot is that the discussion over how and when the great bond-buying experiment might be unwound is getting more serious, which, for risk asset investors, is a little like being told they will have to move out of their parents’ basement and fend for themselves.
After a brief confused rally, equities headed lower, with the S&P 500 falling more than 1.2 percent, while Treasury bonds rallied. That argues that investors view QE3 as stimulus and that the big problem if it ends won’t be who will buy bonds but what will spur growth. On that view when QE tapers or ends it removes a source of funds for the stock market but investors worried about growth will keep buying Treasuries.
If the equities fall extends and lengthens in time, look for Fed Chairman Bernanke or others to give the impression that the solid center of the FOMC is not close to taking action.
The truth is that all risk markets should worry about the Fed’s plan to unwind its $3 trillion portfolio of bonds, and that includes Treasuries, which as a market dominated by a single buyer, are by definition a risky asset.
“If it is true that Fed tightening cycles have never ended without either a recession, a financial disaster or some combination of the two, then it is equally true that a prolonged and intense Fed easing phase has never failed to usher in an era of exuberance followed by a bubble somewhere,” Gluskin Sheff strategist David Rosenberg wrote in a note before the minutes were released.
Most notably the over-reaction to the Long-Term Capital Management blow-up in 1998 meant the Fed kept rates far too low while the Internet mania boomed, leading to a far more destructive bust when rates were finally raised in 1999 and 2000. And of course the disappointing recovery in the early part of the last decade led the Fed again to keep rates exceptionally low — 1 percent — even into mid-2004 as the real estate bubble was building and real and nominal growth were rising reasonably.
It is hard to argue that the cumulative effect of the Fed’s easing this go round is less than either of those episodes, and so you have to wonder if the reaction to the Fed’s tightening will rival 2000 or 2008. And be in no doubt, a Fed selling bonds is a Fed which is tightening, even if it is still far away from raising rates.
US Federal Reserve Board Governor Jeremy Stein maintained in his speech recently that parts of the more exotic sections of the bond market like high-yield were showing signs of bubble-like activity, and it is clear that those markets have benefited by a reaching for yield supported by Fed bond buying. Former owners of Treasuries sold to the Fed find little to like in super-low rates and some of that money finds itself further along the risk spectrum. The day the market believes the Fed is finished is the day that reverses.
Similarly, equities are hugely supported by QE, and will be similarly challenged by its end, whenever that comes.
Finally, who is going to want to buy long-term Treasuries when the Fed is selling? You only will if you think they are doing so way too soon.
There is no easy way for the Fed to unwind its balance sheet, which is maybe the best reason not to take the debate depicted in the minutes too seriously.
— James Saft is a Reuters columnist. The opinions expressed are his own.