Tuesday, August 20, 2013

To Taper or Not To Taper That is The Question

I'm re-focusing today's topic on something I only talked about briefly last post, the US Fed's next move. The market consensus today is that the Fed will start tapering (i.e. slow down QE3 / long dated bond purchases) in September. This has been the case shaping since May of this year when Bernanke did a fumble and made the mistake of saying out loud that tapering could happen as soon as September. He quickly tried to make a U-turn subsequently by going to media to say that no, they were only going to taper if the economic data showed significant improvement.

The market has not cared about Bernanke's frail attempt to calm market fears. As shown in the chart below, US 10 year treasuries have sold off quite drastically relative to the stock market (shown as the S&P 500). This is a normalized chart and not a very typical chart to show, but I thought it neatly showed the relative underperformance of US Treasuries.

Source: Bloomberg

People have been pulling money out of bond funds relentlessly. It's pretty easy to guess where most bond funds have been allocating their money based on how quickly the US treasuries have sold off.

The question going into September is definitely if the Fed will start tapering or not in September. Most people have already factored in at least a $10bn reduction in QE3.

I really don't know why they think this!

In the last FOMC statement in July they revised down their vague Fed language on US economic growth from "moderate" to "modest", the first time in a few years. Only one person dissented from this statement and this was long time dissident Esther George. Everyone agreed on continuing the $85bn in monthly QE3. First quarter GDP growth was revised down from 2.4% to 1.8%. People have all of a sudden forgotten about sequestration (the word we all just learned in 2012) and the negative effect on people's income and employment. For example, an indication of this is Walmart earnings and their negative outlook for the 2nd half of the year. The market gets fixated over every little economic data and the accelerated sell-off in US treasuries is irrational. Why would the Fed pull-back so drastically? They are not stupid. They know a spike in mortgage rates will hinder the housing recovery. They know a spike in borrowing costs will hinder the economic recovery.

Now don't get me wrong: I too am a long term bear on US treasuries as I've said in my previous posts. But let's not get ahead of ourselves please.