Looked at in isolation, the economic data in the United States does not argue for the Federal Reserve to cut back on its bond purchases starting in September. Yet markets and economists continue, in the main, to expect the so-called taper, a process where the Fed begins to reduce the $85 billion per month it buys in bonds, to be announced at its September meeting.
On the face of it, that expectation should have been dealt two massive blows by data about new home sales and the purchase of big-ticket durable goods released on Friday and Monday. Sales of new single-family homes in the U.S. dropped 13.4% in July, as the impact of rising mortgage rates, driven higher themselves in anticipation of the taper, cut into buyers’ animal spirits. The revival of housing, which drives jobs and an array of spending, has been a centerpiece of arguments that the U.S. economy is recovering.
That same cooling is already being felt in the market for new washing machines and heating systems, to judge by the sharp decline in sales of durable goods in July, which fell by 7.3% in the biggest drop since last August. Non-defense capital goods orders excluding aircraft, which is tightly correlated to business spending intentions, fell 3.3%. Core capital goods actually shipped fell by 1.5% in July, the biggest drop since the crisis year of 2008.
Stocks and government bonds rallied on the news, but not in the convincing, full-throated way you would expect if investors had come to believe the taper was off the table.
One of two things seems likely in the coming days.
The Fed, by which I mean Chairman Ben Bernanke and his core supporters, may move to create an impression that the central bank wants to see more, and better, data before it begins to shave back bond purchases. This could be a speech or series of comments by Fed officials, or it could be a story in the press citing sources within the central bank. If this happens, look for a stomping rally, and an equally joyous run-up in emerging markets, which are facing keen currency and funding pressures due to taper anticipation.
The alternative also involves news out of the Fed, but this time indicating that the taper in September is still planned, but perhaps stressing that the impact on the real economy will be slight, or in some other way minimizing it as a formality — the beginning of a long process of normalization. In other words, the taper will happen, but don’t worry, it never was that big a deal in the first place.
If the latter happens, markets will not be happy. In part, risky assets will be hurt because indeed the effect of bond purchases was primarily felt in financial markets, where investors were pushed to take cash they got from the Fed and buy something, anything, with a higher potential return.
However, when the stated reason for something happening doesn’t justify it, it is time to start looking for another underlying driver, perhaps one that is harder and more dangerous to say out loud.
It would be hard for the Fed to say it is tapering because bond buying hasn’t worked that well, and that the risks — of bubbles on the way up and market dislocation on the way out — look like they may outweigh the potential benefits. Central banks don’t like to sound like they are being forced into a position, and no one likes admitting that a gambit has not paid off.
To be clear, there are some bright spots in the economy. The debt burden shouldered by households has improved, and the federal deficit has been declining – from more than 11% of output in 2009 to about 4% his year.
Housing is another bright spot, but that makes Friday’s new home sales that much more chilling. Ten-year bond yields have jumped from 1.63% in May, when the taper talk began, to about 2.8% now, taking mortgage rates higher with them. While a lot of home sales are cash to investors, those investors are actually highly sensitive to the risk environment. As rates rise, cash buyers will fade along with traditional mortgage borrowers.
All this is to say that the emphasis on the taper by the Fed is puzzling if you only take into account what the central bank actually says, and compare it to the data the economy is actually recording. The truth probably is that the taper is good risk management, needs to happen, but will be painful. Don’t expect those words to come out of Bernanke’s mouth, or his successor’s.
— By James Saft. Published with permission of Reuters.