A Gordian Knot? Beware the Taper

08/15/2013 9:00 am EST

Focus: STRATEGIES

Mike Larson

Editor, High Yield Investing

The party line from Wall Street and the Fed is that the process of tapering will be relatively painless. My take? Fuhgeddaboudit. It will be anything but smooth, says Mike Larson of Money and Markets.

Quantitative easing 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% move!

Another recent move 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%, 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.

So, 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.

Dallas Fed President Richard Fisher recently noted in a speech 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."

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.

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.

The 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, 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.

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

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