Why “Tapering” Will Not Go Smoothly — and What That Means for Bonds and Stocks

If you buy the party line that Wall Street and the Federal Reserve is pushing, the process of “tapering” back on Quantitative Easing (QE) will be relatively painless. All the Fed has to do is gradually, slowly, predictably, and gently ease back on its bond purchases and, they say, it will have minimal market impact.

My take? Fuhgeddaboudit … it will be anything but smooth. And this week, I’ll use the Fed’s own comments — and a shocking Fed chart — to show you why.

First, some background.

QE is unlike anything the Fed has previously done in the last century. It was an untested, fly-by-the-seat-of-the-pants policy when policymakers rolled it out in the midst of 2008’s full-scale credit market emergency. No one at the Fed — or anywhere else — had any idea what the long-term consequences would be. But they did it anyway because they had nothing else up their sleeve.

That made it inherently risky from the start. Things went okay for a while, which encouraged the Fed to keep at it … despite the fact the “real” economy didn’t respond all that much.

But beginning this spring, everything started to change. In fact, the last few QE and QE-like moves that overseas central banks have tried have utterly backfired.

Take Japan.

An initial pop in Japanese stocks due to that country’s massive QE effort has now resulted in some of the worst declines — and crazy volatility — in several years.  In just two recent weeks, for instance, Nikkei 225 futures plunged more than 3,300 points. That was a whopping 21 percent move! Swings of several hundred points have become the norm rather than the exception since then.

Massive QE in countries such as Japan has caused huge swings in their stock markets.

Another move this week by the Bank of England is also backfiring. New BOE Governor Mark Carney pledged to keep monetary policy easy until unemployment there drops below 7 percent, a form of forward guidance that was designed to mimic Fed moves here. He also said the BOE could ramp up its $574 billion QE program.

But rather than drive the British currency down and bond prices up, the announcement had the exact opposite effect. That marked the second time in the past few months that monetary policy not only failed completely … it actually hurt the very markets it was supposed to help.

So to recap: You have an untested, emergency program that wasn’t allowed to die after the emergency faded, despite the possibility of significant long-term consequences. And you have key evidence over the past few months that QE overseas is backfiring.

That brings me to the quotes and chart I mentioned at the outset. They come from Dallas Fed President Richard Fisher.

He noted in a speech a few days ago that the Fed is now basically buying every mortgage backed security the industry is issuing … as well as others being sold by third parties. Not only that, the Fed has jettisoned virtually all of its highly liquid, easy-to-sell short-term Treasuries … and hoovered up more than one-fifth of all the long-term Treasuries on the market.

His conclusion:

“The point is: We own a significant slice of these critical markets. This is, indeed, something of a Gordian Knot.”

You can read more about the Gordian Knot legend here. Suffice it to say, Fisher’s reference is shorthand for an intractable situation that’s virtually impossible to get out of.

This stunning chart — from the very same presentation — makes it clear what kind of trap the Fed has created for itself. It shows that the Fed’s balance sheet is nearing a whopping $3.7 trillion — by far the greatest as a percentage of GDP in the history of the country. That compares to about $880 billion back in 2008 before the credit crisis.

Click for larger version

When you consider the massive increase in the size of the balance sheet … and the fact the Fed has effectively “cornered” key portions of the bond market … you can only come to one conclusion. Untying this Gordian Knot won’t be easy. In fact, it could prove to be an epic disaster.

Even the mere mention of a possible future tapering of QE caused key parts of the bond market to suffer their worst declines since the credit market collapse of 2008. So when the actual tapering begins — possibly as early as next month — look out! That’s going to lead to some real market chaos … but also some potentially HUGE profit opportunities for properly positioned investors.

I’ll have much more on that in the days and weeks ahead. But the spot-on advice about bonds I’ve been issuing for the past year — to stay the heck away from long-term Treasuries, municipals, junk bonds, and emerging market debt — still stands.

As for your stocks, stay tuned. With QE backfiring in Japan … backfiring in the U.K. … and on its last legs here in the U.S. … things could get very interesting in the weeks ahead. I’ve been lightening up and taking profits on many stocks, and I remain wary of the possibility of a sharp and potentially deep correction.

In fact, I’ve been recommending select, inverse ETFs that rise in value when sectors like REITs fall. That recommendation is now starting to pay off. I say that because the benchmark REIT ETF, the iShares U.S. Real Estate ETF (IYR), just gave up every single penny of its 2013 gains this week — and looks to be carving out a massive head and shoulders top on the charts.

Bottom line: Do not expect the tapering process to go smoothly. Significant bumps and stumbles are likely, for bonds and stocks alike.

Until next time,

Mike