The Fed Can’t Afford to Taper QE

By: John_Handbury

The Federal Reserve Bank’s balance sheet looked pretty healthy in May this year.  On the asset side of the balance sheet is the large amount of paper that the Fed has bought to supposedly stimulate the economy.  This consists mostly of treasury bonds and notes and mortgage-back securities of a value approaching $3 trillion.

On the liability side of the balance sheet is the money the Fed created to buy these instruments, most of which is in bank reserve accounts, which the banks are not allowed to lend, but they collect a bit of interest.  Treasury Bond and Mortgage-backed Security prices were higher than the Fed had purchased them during QE1 and QE2 and the ongoing $85 billion/month purchases for the third round of quantitative easing, so the process had a net gain. 

The fact that the Fed was actually profiting from this arrangement has no doubt put Bernanke in a good light and provided political support for the process.

However, since Bernanke whispered in May that the Fed will start “tapering” these asset purchases, the market has assumed the worst, i.e., that bond prices will crash without the support of quantitative easing (although historically quite the opposite has happened when these bond purchases have ceased).  Thus bond prices have fallen almost 15% since and yields have soared.  This means the asset side of the balance sheet has fallen about $500 Billion, an amount not to be sneezed at, in fact over 10% of the entire US gross national product earned other those same four months.  This “lost” value could be very deflating.

Also the recent drop in bond prices has had exactly the opposite effect to what the Fed has aimed to do, that is, decrease long-term interest rates.  Interest rates are increasing all along the yield curve and could very easily hinder the fragile recovery we have been seeing.  So the Fed is in an uneasy place right now.  They need to continue buying paper assets to protect the paper assets they already have.  It seems unlikely that the Fed will start an aggressive tapering sequence, especially with Bernanke retiring soon and not wanting to leave a legacy of debt for his QE process as well as a moribund economy. It would be like leaving the casino a loser – very hard to do.

I believe the Fed will be very cautious not to spook the markets and incite a run on bonds and possibly the stock markets too.  They are in a position of great influence at this time with the market reacting to every word they utter.  They know they can significantly improve bond prices at this point simply by doing one thing – nothing new.

By John Handbury

Independent Trader
johnhandbury@hotmail.com

Copyright © 2013 by John Handbury - All rights reserved.

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