Taper Update – Welcome Back Carter | President’s Letter

Isn’t late 70’s Brooklyn a lovely place?

Welcome Back, Kotter was actually a pretty good show at the time, although watched now everything appears so dirty and so decrepit that it is hard to enjoy (full disclosure, I grew up in NY and lived there until 1977). But that was depressed America back then, when everyone smoked and littered, cars were ugly and defective (unlike those great cars of the 60’s that people collect to this day), and we experienced high unemployment and soaring inflation and gas prices. It came to be called “malaise.” Post Vietnam, a lost sense of who we were and what we stood for. A sense we were in decline, and our best days had passed.


Speaking of Fed Policy…

Interesting article from Bloomberg today- Fed Message Muddled as Misunderstood Taper Meets Slowing Growth. As we have discussed, everyone is talking about the Taper– when will this fearsome beast be set loose on us, its hapless victims? People are starting to panic at the notion that interest rates must continue to rise and bonds will be clobbered and… and… well, and what, exactly? First, let’s briefly discuss the economy and Fed policy, and then a mercifully short note about bonds.

As you can see in the article, the Fed, like the US Government, has been consistently over-optimistic about economic growth and everything that goes with it, especially employment and inflation. Growth remains anemic; the forecast recovery keeps getting pushed out a few quarters. Employment, in terms of workforce participation, is down to levels not seen since 1978, when Jimmy Carter was President, as the article points out. Thus, the reported unemployment number of 7+ % is only that low because people are taking low wage part-time jobs or giving up altogether. Feels pretty good, doesn’t it? It certainly does not; this is awful. But it does feel familiar.

Back in the 70’s, the Fed models were based on the certainty that you had trade-offs to make between inflation and unemployment, and you would not have both. Wrong. We printed money, got huge inflation, but unemployment and the economy worsened. The name was “stagflation” and it was terrible. Today, Fed models are making different erroneous assumptions about the impact of Fed policies, and thus we see a failure to grasp reality–they are not getting it yet.

We certainly do not have inflation today, not by traditional measures. The printing presses are running like never before, but the money is sitting in the banks, not being loaned, spent or invested. No real stimulus, and no inflation. Nada. But even so, the fear is that removing this attempt at stimulus will crater what little growth we have. And oddly enough, since the printed money is buying bonds, we fear that printing less will mean buying fewer bonds, meaning lower bond prices meaning higher interest rates. So attempts at creating inflation by printing money to buy bonds keeps interest rates low, but a tighter policy could cause rates to rise. Confused yet? Aren’t we all? No one more so than the Fed itself, I am afraid.


Time to sell bonds?

No. Rates have jumped over 1%, and bonds have had some losses this year. A few key things to consider:

1.  If you could time these things you would be a genius and extremely wealthy. Really, do you want to try some timing?

2.  We always knew that at some point rates would rise by some amount, potentially in a short period of time. And so they have. We also thought that there was a pretty good chance that this kind of rise could happen while equities were rising, which is exactly what has happened this year. That was a good reason not to sell equities and buy more bonds last year, as many advocated. Bonds were not necessarily low-risk anymore, and equities were not necessarily overpriced. Staying the course worked out pretty well again. It often does.

3.  Rates are higher now; you are earning more in your bond portfolio, and managers have better opportunities to buy bonds offering attractive yields. Making a little money in bonds again, why sell now?

4.  Rates rose, but will the next move be another jump in rates? Maybe not. Compared to inflation, interest rates are now offering an attractive real return. Why would they necessarily go higher if the dreaded Taper actually makes an appearance?

Remember too that when the Taper appears, it is likely to be a tapered taper, a very small decrease in bond purchases. Instead of the enormous beast that nearly killed Frank Buck (see our previous letter), this may be a little bitty one. Every sign from the Fed mitigates against any big move, although the Bloomberg article notes that even a small taper would appear inconsistent with the state of the economy and Fed policy as expressed to date.

We have higher interest rates now, the small pain of the bond losses in many cases more than offset by equity gains. Diversification is good. This is no time to start market timing, and if anyone confidently predicts that rates are rising and instructs you to panic and sell bonds, you know better. Be sanguine!

UPDATE (Sept. 18):

Article: Taper off! Fed keeps foot on the easy money pedal

As discussed in our recent articles, the Fed was reduced to doing a very small, essentially meaningless taper, or none at all. They chose no taper. The very weak economy is inspiring no confidence. Sadly, no end to this grim situation is in sight. But as we see today, capital markets adjusted to the bad news long ago, we experienced that in 2008. From here, the markets may continue doing well, and may even reverse some of the recent rise in interest rates.


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Taper Update – Welcome Back Carter | President’s Letter

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