Taper tantrum or Delta?

I don’t think so….

So, the Fed is now thinking about thinking about tapering, i.e., decreasing the amount of liquidity it pumps into the banking system each month. Next would be interest rate hikes.

Frankly, and as I’ve written ad nauseum the Fed has kept the punchbowl out for too long, and just like the 1929 Fed it should have withdrawn it years ago.

But, the real question for markets now is whether the Fed will even be able to taper or run-off the $120 billion a month in purchases, and then normalise its $8.2 trillion balance sheet and get interest rates back to reasonable levels that put a realistic price on money, as a commodity.

I don’t think it will. Last time it tried it was only able to manage a $600 billion run-off and four tiny interest rate hikes before both initiatives were scrapped, the balance sheet grew again, and interest rates were smacked back down to zero.

And, at that time the Fed balance sheet was only half its current size, and global debt was only $169 trillion.

Today global debt is over $280 trillion and more debt needs to be created to service it and roll/refinance it over the long term, and still more is needed to fund ongoing global deficits and additional welfare if Delta does its worst.

But more about Delta later.

Doing simple math - for every 1% increase in interest rates, the world would require an additional $28 trillion to pay for the 1% increase in cost (let alone new debt), which is equivalent to the US national debt!

Meaning, for each 1% increase in interest, you create one new creditor the size of the world’s largest economy. At 3% you wipe out global GDP for one year. In other words, the world becomes insolvent - unable to pay its debts as and when they fall due.

Clearly, with this unthinkable impost, and in the absence of a debt jubilee (ripping up the debt) the Fed and the ECB will be constrained in how much they can taper/normalise before there is another tantrum, and global indebtedness demands that QE Infinity continues.

On top of that, a deep and prolonged stock market drawdown caused by a taper and later rate hike would cause more pain at a time when equities as a % of household investments is at an all time high.

In other words, the can will be kicked further down the road.

So, if you agree with the above, is all the fuss in markets about a dreaded and sustained taper warranted?

Probably not, and the taper if there is one is likely to be short lived. In turn that suggests stimulus will continue to be stacked into the carriages of the QE Infinity train which will speed up again, and equities will again be risk-on.

Refresh.

So let’s go back and see what happened the last time the Fed tried to taper, or as it was know then ‘run-off’ the balance sheet.

A run-off is where the Fed reinvests progressively smaller proportions of the proceeds it gets back from maturing treasuries and mortgage backed securities. That is, $120 billion in purchases becomes $100 then $80 and then lower and lower, etc.

First, below is something I wrote in September 2017 when Fed Chair Yellen as she was then, wisely decided to take the first step in weaning markets of free and easy money, aka, take away the punchbowl.

Click on Ms Yellen for a refresher, but come back once you’ve read it.

Regrettably, in the following year Donald Trump became president and decided that more liquidity and lower rates would be the order of the day.

Chair Yellen was pushed out, Jerome Powell was brought in and Trump launched an assault on Powell’s Fed to push it into reversing the prudent course which Chair Yellen had plotted.

But in resistance, Powell left the run-off on auto-pilot and pushed ahead with increases to the federal funds rate (FFR), and by the end of 2018 there had been four rate hikes with the FFR sitting at 2.25%-2.5%.

The Fed’s balance sheet of $4.1 trillion had been run-off to the extent of $600 billion, to stand at $3.5 trillion. So far so good.

But that’s all that was ever managed. The market had been in a tantrum since before Christmas. And on the 31st of January 2019 in response to the tantrum, Chair Powell confirmed the run-off would be taken off auto-pilot (reinvestments had already decreased to $50 billion per month by that stage) and interest rate hikes would be put ‘on pause’.

In doing so, Powell reopened the equities casino with all punters receiving free credit (and some receiving stimmys) plus a promise that no one would lose - effectively super-sizing the QE Infinity can and kicking it further down the road to nowhere.

Here’s a refresher of what happened. Don’t forget to come back after you’ve read the below.

The last taper lasted for only 12 months, and the balance sheet was only half the size.

After the January tantrum, the balance sheet run-off continued for an additional 7 months.

Then, in September 2019 (12 months after the run-off was announced) Powell’s Fed started buying again!

This took the Fed’s balance sheet back up to $4.2 trillion.

The fact is that the Fed was unable to taper for any longer than a year before reversing its policy and engaging in more quantitative easing (there’s a shock).

The economy was not so good. The tariff trade war was in full swing. People and debt productivity had fallen out of bed, and the Amazon effect, technology and the ageing population were keeping a lid on inflation as they continue to do today.

I don’t think we’re too far off from that kind of scenario, yet again.

And let’s not forget that the Fed failed to deliver on the last taper well before COVID was a thing. And then when COVID hit, his lightning fast double down on liquidity was historic.

Here’s a refresher of how quickly and bluntly Powell’s Fed acted in the aftermath of COVID, at the same time as Mnuchin deployed his pandemic relief welfare programs.

How might it play out this time?

All of the above occurred before COVID and before the threat of rolling lockdowns from new strains, which can occur at any time.

In 2017, interest rates of 2.25% to 2.5% were too high for the level of inflation and additional liquidity to keep the lights on back then, so you can imagine how prohibitive it would be now.

Let’s not forget that COVID was responsible for doubling the size of the Fed’s balance sheet which now stands at $8.2 trillion.

Clearly, at these levels and in the absence of a debt jubilee (ripping it up) the Fed and the ECB will be constrained in how much they can taper and normalise interest rates before costs rise, equities (and household investment assets) get smashed, and there is another tantrum.

In the U.S. in particular, equities as a percentage of total investment assets is the highest it has ever been. So a deep and prolonged stock market drawdown (crash) would probably be more expensive for the government.

So, is all the fuss in markets about a dreaded and sustained taper warranted?

Probably not. Sure, it may well happen, but just like last time a Fed taper in the near term is likely to be short-lived unless and until real growth returns (i.e., not just growth in prices). And let’s also not forget that no other country has tapered since the GFC.

If that’s right, then what’s currently moving the market towards a recalibration is sentiment around Delta and future variants, and the potential for growth to slow further as a result of more lockdowns and supply chain disruptions - a factor that’s not being helped by the World vs. China slugfest.

Thereafter, once risk assets reprice and the market gets its hive mind around the above, it’s likely that equities will start to smash out returns once again.

Mike

Next Level Corporate Advisory is a leading M&A and capital markets advisory with a multi-decade track record of delivering high quality independent financial advice and strategic transactions.

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