Previewing The Market's "Taper" Tantrum

The reason for yesterday's late day swoon was a humorous tweet, which subsequently became a full-blown serious rumor, that the WSJ's Hilsenrath would leak the first hint that the Fed is contemplating preannouncing the "tapering" of its $85 billion in monthly purchases. Naturally, this did not happen as we explained. And yet, judging by the market's response there is substantial concern that the Fed may do just that. To be sure, it is quite likely that in addition to just rumblings out of economists, which are always wrong and thus ignored, that one of the Fed's unofficial channels may hint at some tightening in the monthly flow (if certainly not halt, and absolutely not unwind). Which makes sense: all previous instances of non-open ended QE took place for up to 6-9 months before the Fed briefly let off the accelerator to see just how big the downward response is. The problem now, however, is that even the tiniest hint that the grossly overvalued "market", which has risen only thanks to multiple expansion for the past year, would lead to a massive overshoot not only to whatever an ex-Fed "fair value" may be, but overshoot wildly as the liquidation programs kick in across a Wall Street that is more liquidity starved today than it has been in a decade.

This is precisely what Scotiabank's Guy Haselmann thinks:

"Few care about “right-tail” events, but should investors decide to pare risk in reaction to a hint of ‘tapering’, the overshoot to the downside may surprise many. The combination of too many sellers, too few buyers, and dreadful (and declining) liquidity means a down-side overshoot is highly likely."

We certainly agree.

it is precisely just this illiquidity driven "deflationary" overshoot to the downside in a world which suddenly finds itself without a safety net, that will be just the thing that drags the Fed right back in, and forces Bernanke or Yellen (or heaven forbid, Geithner), to double down on the monthly amount of flow, launching the latest and greatest dollar-crushing, inflation stimulating reliquification tsunami.

Because if we have learned anything, it is that the equity market can no longer function without the Fed's "put" in place at every given moment.

From Scotiabank, on why a "tapering" may be imminent, if only for purely optical and "transitory" reasons:

The bullets below list reasons why the Fed would want to “leak” hints of a tapering now.

  • On Monday morning of this week, the RBNZ (New Zealand) and BoK (Korea) intervened in the currency market to try to dull the strength of their currencies. Soon afterward, Sweden and Chile announced they might have to intervene as well. Poland cuts rates to weaken the Zloty.
    • These actions and comments show that the external ramifications of QE will no longer be tolerated passively. These moves represent a tacit protest against QE. It could be argued that if QE policies do not subside soon, other governments are now willing to retaliate with counter-measures (currency wars, “a race to the bottom”, protectionism).
  • When FOMC members discuss the “costs” of their policies, they are partially referring to the potential for asset bubbles and distortions to price discovery. The Fed has had its foot on the accelerator so long that easing off should provide information from how markets react.
  • In the past 10 days, the yield on the Barclays High Yield Index has collapsed from 5.37% to 4.97%. A 4-handle on Junk bonds is truly remarkable. High Grade spreads have also been tightening materially.
  • Credit Default Swap (CDS) premiums have been declining rapidly and plummeted the past two weeks to all-time low levels. Certainly, marginal buyers have continued to be chased into the market from fears of missing the up-trade and promises of the Fed “put” protecting the downside, but the collapse in CDS premiums represent bear capitulation and the futile results of hedging risk.
  • Equities are higher by almost 15% YTD (46% on an annualized basis). The FOMC wants asset inflation (the Pigou Effect), but trading has become decidedly one way. The S&P 500 has rallied 13 out of the last 14 days. There was increasing talk of equities “melting up” and finally stated publicly by Stan Druckenmiller.
  • NYSE Margin Debt has matched the highest levels in history (July 2007).
  • Tobin’s Q ratio is the best predictor of market corrections (of 20%+). James Tobin won a noble prize for it. He hypothesized that the combined market value of all the companies on the stock market should be about equal to their replacement costs. The Q ratio is calculated as the market value of a company divided by the replacement value of the firm's assets. The ratio is approaching levels similar to 1907, 1929, 1937, 1969, 2001/2, and 2008.
  • The Fed has been accused of ‘enabling’ fiscal stalemate. There is an article in the WSJ today about how improving Federal finances lessens the urgency for Republicans and Democrats to negotiate. Stable and rising asset market prices have the same effect. As negotiations begin, providing a warning shot that the Fed cannot do the heavy lifting forever, may be a wise move.
    • After all, the debt ceiling limit gets hit next week on May 18th, at which point the Treasury will have to invoke extraordinary measures to prevent default (something they can do until September).
  • Congressional and market criticism has been increasing.
  • The Treasury will probably be cutting issuance in Q3 due to an improving position. This effectively means if the Fed continues to buy at the current pace, it would be buying an even greater percentage of visible supply.
  • It is possible that Bernanke made a suggestion about ‘tapering’ in his Chicago speech today, when he used the words “reaching for yield”. The dollar and the bond market are just beginning to notice and react. The other markets will likely soon follow.

Fed tapering would catch the market off-sides. At some level, FOMC members must realize they have created a moral hazard dilemma and conditions of over-promising what they can deliver. Tapering would symbolically put a dent in market sentiment and the implicit ‘put’. The many investors that have been drifting into riskier assets in a scramble for yield would begin to prudently re-focus on the downside risks to these assets.

It is possible a steep decline in financial assets would ensue with the lowest part of the capital structure being hurt the most. The Fed has chased investors all in the same direction; into risk-seeking securities. Few care about “right-tail” events, but should investors decide to pare risk in reaction to a hint of ‘tapering’, the overshoot to the downside may surprise many. The combination of too many sellers, too few buyers, and dreadful (and declining) liquidity means a down-side overshoot is highly likely. It would provide the Fed with their answer as to whether they have been creating market bubbles.