I’ll bet most people thought Wednesday’s taper announcement from the Federal Reserve was its second. Everyone likely remembers what everyone assumed had been the first; the one in 2013, punctuated beforehand by the fabulous “tantrum.”
Eight years ago was really the second, though third in actual tapering. The Fed’s very first had been undertaken in August 2009. And that one had essentially been two different alterations conducted simultaneously. At that time, QE1, the program purchased both US Treasuries as well as MBS.
The pace of buying the former asset class would get scaled back over a period of two months, so that by October 2009 QE1 would no longer include any UST purchases. The latter, MBS, the lessening in monthly buying got spaced out over six months, terminating the whole thing by March 2010.
At issue, for policymakers, anyway, was the stock versus flow argument. Despite having a wealth of empirical answers about large scale asset purchases (LSAP, of which QE is one) provided from Japan long before 2008 and 2009, central bank officials remained entirely unsure over the details about how it really might work (or not).
Staffers had conducted statistical exercises, sure, becoming who knows how many tens perhaps hundreds of thousands of Monte Carlo simulations. The real world just isn’t an econometric model – a point demonstrated to society’s very real detriment beginning August 2007 which ironically led the Fed to this first QE.
Trusting instead the Japanese problems with their LSAP’s were due to problems with Japan’s execution of them, theoretically “bond buying” still could produce benefits in three ways: sentiment, the presumed positive public response to a central bank doing whatever a central bank might do it says is accommodative; portfolio effects, which remove safe assets from commercial banks forcing them to go out and do risky activities to replace those assets; and, lower interest rates, the most obvious and allegedly straightforward of the trio.
It stands to reason that a non-economic actor such as a central bank which begins buying up a substantial number of any type of assets, the price of those assets would quite naturally rise; ceteris paribus. If the price of X is A, and all of a sudden in comes Ben Bernanke with a multi-hundred billion mandate, it seems reasonable to believe the price of X will quickly grow to B, being much greater than A.
But is that because the central bank bought Y number of bonds; the total? Or is it because the central bank ended up with Y after having stayed in the market for Z number of months?
Stock vs. flow.
This argument would come up (a lot) in early 2011. For reasons that are never adequately addressed – to this day – Ben Bernanke’s FOMC decided after having tapered then terminated both parts of QE1 earlier in 2010, and then watching the world go haywire over the next few months, what choice for the Chairman except another round of the same thing (QE2) before even getting into the next year.
Closing in on QE2’s by March 2011, officials began to consider what would have been Taper #2 (meaning, the third taper; yes, I’m using central bank math). In other words, did QE2 need to be tapered first like QE1 had? This thinking put its positive effects into the “flow” bucket; as in, the anticipated market effect, lower interest rates, was due to the regular buying rather than how much overall in total.
Many that March had come to believe, no, QE2 could abruptly end without any need for scaling back first. Whatever good it had done, and they really believed it had done a lot of good, this was because of “stock” effects; that the goodness was generated by the total amount of bonds rather than the monthly transactions however much each month.
“MR. SACK. One of the reasons behind the decision to taper purchases during the earlier programs [QE1] was to allow the markets to transition smoothly to our absence. At that time, we faced greater uncertainty about whether the stock or flow of our purchases drove the effects on market pricing, and hence there was some concern that abruptly ending the flow of our purchases could cause the yields on those assets to move up sharply.”
The above taken from the March 14-15, 2011 FOMC transcript which featured a lengthy discussion of taper or no-taper, stock and flow. Many Fed officials had expressed fears of an impending interest rate spike should the central bank fail to allow the market to adjust first.
This never happened, you might remember. Rather than skyrocket, yields went the opposite way – especially by April 2010 when every part of QE1 had been ended.
“MR. BULLARD. I just want to follow up on the tapering issue. I was a little surprised that it has become the default that we would end abruptly, and I thought that, as you described, the end of the MBS purchase program was successfully tapered. There was a lot of market talk at the time that if the Committee didn’t continue MBS purchases, mortgage rates would go up sharply. That was effectively mitigated by our tapering program, and not too much happened when we pulled out of that market.”
To several of the Committee members, including James Bullard, this argued for another taper rather than any hard stop. After all, he “reasoned”, it went so well the first time; no yield surge.
In other words, the argument here was whether successfully navigating the flow of purchases had been responsible for stopping that outcome, or if it had been the stock all along. Brian Sack, the Open Market Desk Manager in March 2011, claimed the Fed’s research was clear in how it had been the latter:
“MR. SACK. This pattern [2010’s yields] suggests that the Treasury purchases in the current program could end fairly sharply without causing a significant rise in Treasury yields, as long as the expected stock of our holdings remains steady.”
In this other view, the Treasury market was apparently more concerned about the possibility of central bank selling the assets bank into the marketplace (as had been the case in 1948-49). If the Fed bought up a bunch of UST’s while also committed to keeping them for the long haul, the flow argument faded into obscurity.
This was already the prevailing view, and the FOMC in March 2011 decided that, unlike August 2009, no taper would be necessary. All of QE2 would come to a sudden end in June.
By then, interest rates – bond yields – had neither skyrocketed nor remained very stable. Instead, contrary to every mainstream expectation (and likely pretty much all of the Fed’s modeled simulations), it would be US Treasury prices surging.
Between early February 2011 and the time when QE2 finished up, the 10-year UST yield had dropped almost 90 bps. It would then rise a touch over the few weeks after, before rates absolutely plummeted July and early August.
Interestingly enough, back in March, the very day after the FOMC meeting, the Treasury curve had seen its most sustained bidding to that point. On March 16, the 10-year yield declined by 11 bps on that single day; the 5-year rate shed 13 bps. Stock effects?
The “unforeseen” market action was immediately attributed to Japan; though, in this case, the Earth’s effects on it rather than the Bank of Japan’s suspect impact on anything. According to CNN (and pretty much every other media outlet):
“The increasingly desperate situation at Japan's nuclear plants is keeping investors on edge. Stunned by the devastation in Japan, they have been reducing their exposure to risky assets and flocking to investments that are considered safe, including U.S. Treasuries.”
At least they got the direction of interest rates right; if the world in general is becoming materially riskier, then who wouldn’t want to own safe and liquid instruments regardless of whatever the central bank is doing? The question then was, was it really Japan’s tragedy creating such desire for the risk-less?
If earthquake, then very quickly the world gets back to QE and taper, a growing distaste for safe and moved substantially higher even if that didn’t mean an unruly spike at some point.
“MR. HOENIG. My point is that we need to move to a more balanced policy. Specifically, we need to be, again, preparing the market for a rate increase soon…where yields are at historical lows. That is what we need to be thinking about.”
Remember, also, what “everyone” was saying about inflation back in early 2011. As bad as the hysteria and certainty has been this year, it was pretty much the same a decade ago. From corporate CEO’s to practically every Economist any financial media reporter could find to comment, the cry of “money printing” and “out-of-control” consumer prices had been uniformly rampant.
As late as November 2011, Deutsche Bank Chief Economist Joe LaVorgna had written, “Contrary to some monetary policymaker protestations, we believe the rise in food and energy costs is highly unlikely to be temporary…” LaVorgna was hardly alone.
For most people, as the 2011 CPI skyrocketed, it had to have been QE2 which kept bond yields from reflecting this massive “inflation” in addition to being the cause. The money printing was coming home to roost, and the Fed was to blame for rates as well as consumer prices. CNBC, among everyone else, connected these (imaginary) dots (Ugly Truth for the Fed: Inflation Pressures Here to Stay):
“M1, which includes currency, travelers checks, and demand and other deposits, is up 21 percent over the past year. At the same time, M2, a more closely watched inflation gauge that includes M1 plus savings and time deposits and retail money funds, has risen 10 percent.”
The Fed’s view was that there was just the right amount of monetary “accommodation” so that that QE2 could conclude without the need for taper. The prevailing financial opinion was that they’d regret being too sanguine, having unleashed high inflation risks which would shortly lead to a more aggressive rate hiking campaign than even Thomas Hoenig had been urging.
Before going much further, the global bond market would arrive at what I call today a landmine. Tapering or ending QE, those were all distractions that those in the bond market cared nothing about.
This is the market saying, unequivocally, the situation has deteriorated beyond some point of no return, from which there will be no inflation potential nor even much chance at legit growth.
It's why I call it the landmine; once the monetary system hits upon one, there will only be economic pain from there forward.
This was proved to be the (eerily similar) case in November 2018, like it had been also in December 2014. Before then, 2011’s landmine was reached during that July’s yield plummet.
In between the taper debate of March and emergency FOMC meetings by August, not even five months later, the grossly destructive implications following the Treasury market’s 2011 landmine had registered even with the Fed’s Committee of the Monetary Blind. By August 9:
“MR. SACK. [W]e are seeing funding pressures emerge. We are seeing a lot more discussion about the potential need for liquidity facilities…So the liquidity pressures are pretty substantial. And I think it’s worth pointing out that this is all happening with $1.6 trillion of reserves in the system.”
Bank reserves were meaningless. Discussing the presumed merits of tapering or not tapering was itself meritless. There were no differences between stock or flow since there was nothing gained by QE.
Busy little bureaucrats had carved out a living interpreting the strange shadows dancing upon the walls of their restrictive little cave having no bearing on the actual outside world.
QE certainly did not lower interest rates (as even central banks nowadays quietly admit); the market sets them and it doesn’t really care for a second the imaginings of theoretical statistics. Either the program works; or it doesn’t. It fixes a real-world money problem, creating a realistic path to recovery and some inflation; or it leads the mainstream to perpetuate a fairy tale, a myth about “money printing” which then leaves the entire world exposed to the same monetary deficiency which had originally provoked the ugly cycle.
The bond market can tell the difference and can tell you the difference.
Here we are all over again in early November 2021, with Taper #3 (meaning four) coming at us and, lo and behold, bond yields are dropping (with the yield curve already flattening). Are the chances for a bond selloff way up, the likelihood of rising rates more certain without the Fed buying as many bonds going forward? Is inflation really the greatest risk right now as absolutely everyone still says?
Or, might the global system be moving back toward the (same) monetary minefield with basically no one heeding all the (same) warning signs posted everywhere in advance of it?
There is one thing for sure. You won’t find any answers in taper.
