Billionaire hedge fund manager, David Tepper, made news this week when he
emphatically stated that investors have nothing at all to fear regarding the
eventual tapering off of Fed's $85 billion worth of monthly debt monetization.
His assertions were based on the fact that our annual deficit is shrinking
and would thus require less of Bernanke's money printing.
Besides the fact that the deficit for fiscal 2013 will still be about $500
billion higher than it was before the Great Recession began at the end of
2007, markets have two other reasons to fear the cessation of quantitative
easing. What Mr. Tepper doesn't realize is the end of QE will cause the U.S.
dollar and interest rates to soar. And that will have devastating consequences
for the markets and economy in the short term.
Since February of this year, the dollar has increased by 6.3% against our
six largest trading partners. Just imagine how it would then surge if the
Fed were to start aggressively reducing its bond-buying program...especially
in light of the surging debt monetization now occurring over in Japan and
the protracted recession in Europe. Of course, a stronger dollar would be
greatly beneficial to the American economy in the long term, as it engendered
a period of deflation that is needed to reconcile the current imbalances of
debt, money supply and asset prices. However, that same deflation would likewise
do significant damage to equity prices; as it also vastly lowered the revenue
and earnings of S&P 500 corporations.
But the most important problem if Bernanke were to taper QE this summer and
bring it completely to a halt by the end of this year, is that the market
would then begin to factor in the unwinding of the Fed's near $3.5 trillion
balance sheet. This would, at the very least, cause interest rates to rise
back towards the forty-year average of about 7% on the Ten-Year Note. Interest
rates have already been around zero percent for nearly five years. The condition
of artificially produced low rate for years on end causes the economy to become
addicted to cheap money. Misallocations of capital and economic imbalances
occur; like bubbles in equities, real estate and bonds.
In 2007 the real estate bubble popped once the cost of borrowing money to
purchase over-priced homes became unaffordable. This caused banks to become
insolvent because their assets were primarily involved with real estate loans.
Insolvent banks and over-leveraged consumers sent the economy into a depression.
Today, banks and consumers have deleveraged on the margin, but the government
has vastly increased its borrowing. At the start of the Great Recession, we
had $48.8 trillion in total debt and our GDP was $14.2 trillion (343% debt
to GDP). At the end of Q4 2012, the U.S. economy had $53.8 trillion in total
debt sitting on top of a $15.8 trillion economy. The current debt to GDP ratio
Therefore, we can be sure rising interest rates will bring down the economy
this time just as it did six years ago because the total debt to GDP ratio
at the start of the Great Recession is exactly the same as it is today. The
only difference is the interest rate attached to that debt has been artificially
reduced to the low single digits. When rates rise, as they will if the Fed
aggressively tapers QE, the government will then learn it does not have the
tax base to service its debt.
This is why every time the Fed threatens to end QE the markets tumble and
why Tepper, and investors, should fear the eventual taper. Evidence of this
fear is abundantly clear. On February 20th the minutes of the January FOMC
meeting were released, which indicated members of the Fed were growing concerned
about the amount of asset purchases. That very same day the NASDAQ dropped
1.5% and commodity prices tumbled.
In addition, stock market gains appear to have decoupled from market fundamentals
and are merely clinging to the hope of endless Fed credit creation. This week's
economic data was profoundly anemic, yet markets still rallied. On Wednesday
news came out that Industrial Production dropped 0.5% in April, and the Empire
State Manufacturing Index fell to a minus 1.4 in May, from a positive 3.1
in April. Also on Wednesday, we learned that France entered into a double-dip
recession and Europe's recession extended into its sixth straight quarter.
Nevertheless, the S&P 500 gained 0.5% that day.
The following day's economic data was just as bad. On Thursday we learned
that the Philly Fed Survey dropped to a minus 5.2 in May, from a positive
1.3 in April, and Initial Unemployment Claims surged 32k for the week ending
May 11th. However, the S&P 500 spent most of the day on Thursday in positive
territory; until 2:30pm. That's when San Francisco Fed President John Williams
said in a speech, "We could reduce somewhat the pace of our securities purchases,
perhaps as early as this summer, and end the program late this year." The
market cared nothing about the current weak economic data but was very much
concerned about the threat to end QE. The S&P quickly sold off 0.5% once
news broke that the Fed may begin slowing its asset purchases.
The truth is rising debt service payments on government debt will wreak havoc
on the economy just as it did for real estate and banks back in 2007. Artificially-produced
low interest rates, record amounts of debt and inflation targets set by central
banks make for a very dangerous cocktail. An expeditious tapering on the part
of the Fed from QE may be the prudent and necessary thing to do for the long-term
health of the country, but it would also send markets and the economy into
a cathartic depression in the interim.