To Taper or Not to Taper

The FED has been buying $85 Billion worth of Treasuries and Housing Debt securities each month since they announced QE3-4. This amount has roughly balanced the huge Budget Deficits coming out of Washington DC.

All these bond purchases (in addition to the “normal” buying to control the short rate side) have worked to keep interest rates lower than a Free Market would have set. The ultra-low rates in turn have worked to keep the US Budget Deficit from being worse than it already is, by lowering the interest paid out – a significant sum when you consider that there is $17 Trillion of US debt.

In recent months, however, middle and long rates have begun to move up quite a bit - nowhere near a Free Market rate, but a significant increase in any event. But, if the FED is covering the Budget Deficit, then why are rates rising? The answer is that foreign holders of previously issued Treasures, not only China and Japan but other countries as well, have halted their Treasury purchases, and since the Tapering talk began, they have been selling.

Their selling over the last couple of months has been fully half as big as QE3-4. Such selling pushes prices down, and interest rates are pushed up.

As the prices of the Treasures that other countries hold falls, the value of their massive cache of Treasuries falls, giving them more reason to sell.

So now, next week the FED may announce that they will Taper by perhaps $10 Billion a month. If they do, then they remove demand while foreign holders have increased supply, bond prices will fall some more, and rates will rise further.

Add this higher interest cost to the already higher cost these last couple of months, and the US Budget shrinkage that we've seen since the Sequester began, will evaporate. The Budget Deficit will go up, causing the Treasury Department to issue even more new Bonds, making the awful situation look even worse.

All this comes at a time that a new Debt Ceiling agreement needs to be negotiated. I expect more of the brinksmanship and cowardly cave in from Congress, but in the meantime, it will make the US look more like one of the PIIGS countries. This hardly is the stuff that confidence is built upon, and we may expect more Treasury selling overseas and more world financial turmoil.

But the FED is doing more than just QE3-4. As mentioned earlier, they buy short duration Bills and Notes to control rates. I expect misdirection from the FED. (What!! They've never done that before!) They may announce a Taper next week, since all their trial balloons have backed them into a corner. But the reality will be that their non QE3-4 purchases will increase to balance (or exceed) the Taper.

Don't think they would do such a thing? They already are doing it. As I write, the yield on 3 month maturity Treasuries has gone down to 0.0%, AND the yield on 6 month Treasuries today also hit 0.0%. That takes a lot of FED buying. We should expect that to continue regardless of what the FED announces on the Taper next week.