How Fed 'Tapering' Affects the Market

05/23/2013 9:00 am EST

Focus: MARKETS

The Fed's ongoing reduction in bond purchases, however slow or disguised, may have far-reaching consequences, writes John Bougearel of Structural Logic CTA.

Several events have allowed the Fed the flexibility to reduce its $85 billion a month purchases of US Treasuries and mortgage-backed securities over the next four to six months.

The Bank of Japan's $78 billion a month purchases of JGBs (government bonds) indirectly allows Japanese pension funds and insurance companies to seek out foreign assets such as US Treasuries over the next two years. This allows the Fed to not be the buyer of last resort for US debt, at least over the medium term.

Secondly, the "statutory" debt limit will be reached on May 18, but the "effective" debt limit won't be reached until this fall.

Bruce Krasting says there will be a reduction of new Treasury debt issued after May 18. "Under normal conditions, the Treasury would have about $200 billion of wiggle room on the debt limit before there is a crisis. But in the summer and fall of 2013, the Treasury will reap an additional $60 billion of revenue from (incredibly) Fannie and Freddie.

"Based on this, the debt limit will not be a problem until sometime in October. So the reality is that over the next six months or so, there will be a shortage of new issue Treasury paper. This fact gives Bernanke the opportunity to reduce QE without a big sell-off in the bond market."

New US Treasury Secretary Jack Lew concurs, stating that " the one-time payment [$59.4 billion] that Fannie has announced makes it pretty clear that we are not going to hit the "effective" deadline until at least Labor Day. The statutory debt limit will be reached in just a few days when it expires on May 18, but because of the extraordinary measures that are available and cash flows that we now can predict, [the effective debt limit] will not be [reached] until at least after Labor Day."

This confluence of events sets up yet another Potemkin message—that this new "tapering monetary policy" is the beginning of a viable exit strategy from unconventional monetary policies. I am not so sure.

Yes, the experiment will be largely successful. But what happens when these extraordinary measures and one-time payments are no longer available to the US Treasury? Will the Fed then have to flip-flop from tapering policies and back to more unlimited QE policies to accommodate the new expanded debt limit in the fall?

The policy should be dollar-supportive and bearish Treasuries, gold, and equities. The dollar has recently strengthened, while Treasuries and gold weakened. Will there be follow through? Or will the effect be muted, as some believe?

I tend to concur. I think there is much less than meets the eye to this tapering policy, and risks will be undermined or supplanted by further QE policies when the debt limit is reached in the fall.

A tapering of the Fed policy for four to six months suggests US equities could also "taper off" here a bit. They have certainly arrived at a technical reversal pattern on the daily chart known as Three Little Indians.

The trend remains extremely bullish, and year-to-date, we have only seen two minor corrections—a five-day correction that threw the S&P 500 back to its blue quarterly average price in April, and a three-day correction in February related to the Italian elections.

What intrigues about the bearish Three Little Indians reversal pattern is that the high of each Indian on March 15, April 11, and May 9 all occurred on Thursdays. And the last Little Indian occurred on the eve of the Fed's adopted shift to a new "tapering policy."

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