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 As I have mentioned before, I dislike offering comments on current activity in the financial markets.  However, a number of readers of my blog have asked about this topic, and there appears to be quite a bit of disinformation and misunderstanding about what the Fed taper actually is.  Thus, I thought it would be valuable to take some time to discuss this subject.

Before I dive into my commentary on the Fed taper, I wanted to set the stage.  What exactly is the Fed taper?  Well, the Federal Reserve has a policy called quantitative easing (QE) which is now in its third form via QE3.  The Federal Reserve is trying to inject more dollars into the monetary base to keep interest rates at historically low levels in the US economy.  The most effective way to do this on a large scale is to buy US Treasuries and mortgage backed securities (MBS).  In fact, the Federal Reserve is buying $85 billion worth of these securities each month.  If this sounds kind of odd, it is in certain respects.  The Department of the Treasury issues US Treasury bills, notes, and the long bond, and then the Federal Reserve purchases some of those securities at auction.  Some estimates have been that the Federal Reserve purchases some 70% of the new supply.  Yes, it is a very interesting phenomenon.

If you have been watching the financial media or reading financial news publications, you are inundated with information of how the Fed taper will have dire consequences for the stock and bond markets.  The Fed taper is simply that the Fed will buy less than $85 billion worth of securities per month.  Now no one knows if that will happen next month or by how much the Fed will reduce its purchases.  The taper does NOT mean that the Fed will be raising interest rates.  Interest rates are going up on their own.  Market participants are figuring that there will not be enough demand to soak up the excess supply when the Fed reduces its purchases.  The target rate on the Federal Funds is still 0%, and the effective rate for Federal Funds is still around 0.10-0.15%.

The more interesting thing is that the S&P 500 has not gone down since interest rates on the US 10-year Treasury have started on its “meteoric” rise.  The 10-year bottomed out at a closing yield of 1.62% on May 2, 2013.  The S&P 500 closed slightly above 1,597 on that same day.  Even with today’s (August 27, 2013 to 1630.48) selloff in the stock market, the S&P 500 remains above that level.  Therefore, when you hear guests on financial media shows talk about the taper destroying stock values, you need to take that with a grain of salt.  What will happen in the future?  That is the real question.

The US economy has been operating with negative real interest rates for the past five years.  What are negative real interest rates?  Negative real interest rates occur anytime the nominal (actual) interest rate on a security is less that the rate of CPI (inflation).  You are receiving interest, but the purchasing power of your dollars is less.  Even though interest rates are going up now, financial pundits are forgetting that this is not a typical increase in interest rates.  An increase in interest rates, when real rates are positive, tends to slow down the economy.  We have not seen an environment where real rates were negative and now they will be flat or positive.  You should want real interest rates to be positive.  It is the sign of a growing and healthy economy.  When I used to work structuring bond deals, the head of our trading desk would always comment on economic data.  If GDP growth was higher than expected, interest rates went up.  If more jobs were added, interest rates went up.  Why?  Good news about the economy meant that there would be more demand from businesses for borrowing.  Now this was happening over six years ago; however, economic data normally affects the bond market in this manner.

Here is what you need to worry about?  If the Federal Reserve decides that it is time to raise the target rate for Federal Funds that is actual tightening of monetary policy.  The real “black swan” is the Fed’s balance sheet.  After buying all kinds of securities over the course of QE and during the 2008 financial crisis, the Fed’s balance sheet has ballooned.  The Federal Reserve now holds over $4 trillion in securities.  If the Fed ever decides to shrink its balance sheet, they will have to flood the bond market with supply.   Offloading hundreds of billions of dollars or more of bonds will certainly wreak havoc on the financial markets as a whole.  Until the Federal Reserve actually raises interest rates and/or reduces its balance sheet, there is no reason to panic and sell all your stocks.  It just does not make much sense.  The Fed taper will lead to a rise in interest rates.  It is normal.