A Taper Tantrum or Something More?
September’s financial headlines were dominated by reporting on the Federal Reserve Open Market Committee (FOMC) meeting on 21–22 September, and their policy announcement and economic projections unveiled on 22 September. Markets responded approvingly in the following trading days.
At this time, they confirmed expectations that they would begin tapering asset purchases in November. With the tempo they suggested, the taper would be completed by July 2022. At that point, the money printing will be over, and the Fed will be poised to begin raising interest rates, the so-called lift-off.
Investors should understand that all this talk from the Fed was nonsense. The Fed has one of the worst forecasting records of any financial institution. It is consistently wrong in its forecasts by orders of magnitude. The Fed cannot make accurate predictions six months forward. The idea that these two- and three-year projections are accurate is absurd.
This photo might be called ‘Fed in the Time of COVID’. It shows Fed Chair Powell seated alone in the board room in Washington for an FOMC meeting. The FOMC meeting is usually packed with 40 or more participants, many seated along the walls. I was once a guest of the Fed and able to visit the board room. The Chair usually sits in the middle of the long side, back to the windows.
The forecasts described above are from the dot plot where members of the FOMC and other regional reserve bank presidents are allowed to offer their forecasts. The various forecasts are put on a graph as dots. TV talking heads then average the dots and present these as Fed estimates.
I spoke about this to the ultimate Fed insider who has worked for Ben Bernanke, Janet Yellen, and now Jay Powell. He’s the one who composes the Fed’s statements and forward guidance. He told me the dots ‘are a joke’ and that no one inside the Fed takes them seriously. He also told me they ‘wish they had never started’ the dot plot but feel they have to continue it because the public and Wall Street expect it. That’s fine; at least he was being honest with me. Still, the dots are a joke and there’s no need to give them any weight in our analysis. In fact…
The Fed is impotent, and its actions do not affect the real economy
Fed announcements and the dot plot are pure theatre. The real economy is slowing for many reasons that have nothing to do with the Fed, including high savings rates, low velocity (or turnover) of money, slack in the labour market, disinflation, and the slowdown in China.
Nothing the Fed is doing will make any of these things better; in fact, the Fed taper in November will probably make them worse. The Fed will be tightening just as the economy is slowing on its own. This will continue a long tradition of the Fed taking the worst possible actions at the worst possible time.
Taper tantrums are unlikely during this new taper. The reason is that bond markets understand that the Fed doesn’t know what they are doing. The 2013 taper tantrum happened because the taper was believed to signal a return to strong growth and higher interest rates. Leveraged investors quickly unwound carry trades where they had borrowed in yen and invested in emerging markets. When the taper signalled higher growth in the US, capital flows quickly shifted to the US, which caused a disorderly reaction in emerging economy stock and bond markets and currency markets.
This time, investors know that there will be no strong growth, and the Fed’s economic projections are simply wrong. As a result, market participants have not made leveraged bets on strong economic growth, so there’s no need to unwind any carry trades.
It’s a bit of a paradox. On the one hand, the Fed is irrelevant. Their policy actions have no impact on the real economy. They can print as much or as little as they like, but the resulting money supply is completely sterilised in the form of excess reserves held by banks at the Fed. The money doesn’t go anywhere; it is not lent or spent, and it doesn’t show up in the economy. This is evidenced by still-declining velocity and now, emerging disinflation (to replace the false narrative of inflation).
On the other hand, to the extent that markets believe the Fed matters, there may be a short-term impact. If markets believe that Fed tightening indicates a stronger economy, they will bid up stocks. That’s a false narrative, but it is powerful. We’ve seen that in the quick stock market recovery from the mini crash on 20 September 2021. Investors didn’t panic. They saw the drawdown as another chance to ‘buy the dip’. They believe the Fed has their back.
So what is reality?
Meanwhile, in the Treasury note market, serious players know the real story. Declining yields since March 2020 are a sure sign that bond market investors expect weaker growth. Yields will continue to decline as they have in stages since last March. The bond market has a much better record of accurate forecasts than the stock market. The bond market still presents opportunities for capital gains for those who buy five-year and 10-year Treasury notes today.
Once again, we see signs that tension is building between the false narrative (stronger growth and inflation) and reality (weaker growth and disinflation). Reality always wins in the end, but it can take time.
All the best,
Strategist, The Daily Reckoning Australia
This content was originally published by Jim Rickards’ Strategic Intelligence Australia, a financial advisory newsletter designed to help you protect your wealth and potentially profit from unseen world events. Learn more here.