Whenever people hear the word "taper" they may associate it with actions taken by a seamstress or tailor. You may associate the term with a diet. The modern lexicon introduced the term taper as it pertains to monetary policy. Our monetary lexicon has also given us Quantitative Easing (QE). While the verb form of the word taper means to diminish gradually, QE is deceptive in that the "lessening" occurs indirectly. Let me explain.
QE is what the Fed does when they create artificial money (since it comes from nowhere) in order to buy assets such as government obligations and mortgages. The intent is to provide a market for these interest rate sensitive instruments and thus keep interest rates low. So there is no "easing" since the Fed is going all out to buy assets though they hope to "ease" interest rates with their action. When the Fed announced the last round of QE, known as QE 3, they pledged to buy $85B of instruments per month. For those scoring at home, that means they were going to purchase $1 trillion of these things over the course of the year. This action is quite a deviation from the initial intent of the Fed which was to provide liquidity in the banking system to avoid the financial panics preceding its creation. Now the Fed aims to keep interest rates low, reduce unemployment, and levitate the stock market - quite a task for a bank!
Of course pledging to buy $1 trillion of assets on top of the other trillions they had already purchased since 2008 made some wonder how long the Fed would continue their shopping spree. Some even coined the term QE infinity, implying the Fed could continue forever. Perhaps not. All of these assets purchased will be sold at some point. After all the Fed is a private entity and they have no interest in holding a bunch of low-yielding and even questionable assets.
Thus we have the announcement last week of the Fed "tapering" their purchases by $10 billion per month. Why did the Fed reduce their shopping spree? Some may suggest the economy is healthier and less QE is needed. This assumption may be largely based on a lower unemployment rate, a leaping stock market, and an upwardly revised GDP growth in the third quarter. I won't debate these assumptions here.
What I can address is the impact of Fed QE policies on investments. Remember when a nice conservative portfolio meant earning 5-6% on bonds or certificates of deposit (CD)? CD rates have not been that high since 2000-2001 though even in early 2008, they were still between 3 and 4 percent. We no longer have such portfolios. The result is that everyone, and I mean everyone, is chasing yield. By this I mean that investors now have to search for higher interest rates elsewhere. These Fed-induced distortions have been a disaster for savers and those on fixed incomes.
Additionally, the search for yield has increased derivatives exposure worldwide. Those derivatives are rumored to have notional values in sums too large to put into your handheld calculator. Derivatives, as defined in this context, are private contracts between banking institutions, hedge funds, and other investors that bet on a particular financial outcome, many tied to interest rate movement. Futures contracts are also derivatives but they are regulated and traded publicly on exchanges. The derivatives market resides largely in a shadow arena. When you have so much investment in private contracts, a repeat of 2008 is not outside the realm of possibility. Investors get panicky and liquidity dries up and then assets have to be sold to raise cash. In the extreme case, you have firms that go out of business or require Uncle Sam's help.
The markets since 2008 have been a great trader's market. The great majority of investors are not traders. They want to put their money somewhere and not have to think about it. Unfortunately, investors placed money in areas where much thought will be required. Historically the average investor delays their exit from losing positions and jumps in near the end of a trend, deadly character traits for someone who is a trader. The Fed taper does not materially change what our central bank is doing. They are still buying a boatload of assets. The Fed has become an academically driven institution that continues to experiment with the economy. Investors are waiting to see what the Wizard will do next but even the Wizard does not know.
Jim Mosquera is the author of Escaping Oz: Protecting your wealth during the financial crisis.