The word of the day, of the week, and perhaps even of the month in the financial markets is…tapering. Tapering is every bullish investor’s worst fear. It doesn’t matter if you’re a bond investor or a stock investor. If you’re bullish in either market, you do not want to see tapering.
What is tapering? Currently, the Federal Reserve is buying $45 billion of U.S. Treasuries and $40 billion of agency mortgage-backed securities (MBS) per month to try and stimulate the U.S. economy. However, the Fed is not going to be doing this forever. At some point, they will have to stop buying all of these assets. Tapering is the term that has been picked up in the financial press that represents this gradual reduction in buying by the Fed.
The two big questions surrounding this expected tapering are:
- When will the Fed start tapering?
- How quickly will the Fed’s buying taper off?
As you can see in Figure 1, according to the Federal Reserve Bank of New York’s most recent Responses to Survey of Primary Dealers, the earliest anyone expects any tapering, or the announcement of any tapering, is December of this year.
However, the majority of those surveyed believe the Fed will have completely stopped its asset purchase program by April 2014.
Interestingly, even though we haven’t actually seen any tapering by the Fed, and most analysts say they don’t believe tapering is going to happen soon, investors are already jockeying for position, just in case they are wrong.
You can see this on the chart of the CBOE Volatility Index (VIX) in Figure 2. Since the beginning of 2013, the VIX has been forming a rounded bottom with a strong resistance level at 15.
The VIX broke up through 15 in late February and again in mid-April when investors started getting nervous about a potential pullback in the S&P 500, but it quickly pulled back down below that level once market fears abated. Well, we are once again seeing the VIX climb above 15. Traders are bracing themselves for a potential downturn.
At the same time, we are seeing yields on U.S. Treasuries start to rise. Most notably, as you can see in the CBOE Interest Rate 10-Year T-Note (TNX) chart in Figure 3, the yield on the 10-Year note has risen back above 2%.
Typically, this would be a good sign for the stock market because Treasury yields rise when Treasury prices are falling, and falling Treasury prices are typically a signal that investors are rotating money out of Treasuries and back into higher-yielding assets, like stocks. However, this decline in Treasury prices and rise in Treasury yields is more likely a signal that investors are trying to get out of their long Treasury positions before the Fed starts tapering and stops propping up the value of Treasuries by buying $45 billion worth of them each month.
It’s important to note here that we are still seeing bullish signs in the stock market. More and more money is flowing into stocks, margin debt levels are at all-time highs and hedge funds are levered up as much as they were before the financial crisis, but if bond investors are worried about tapering, stock investors need to take heed.
The question is, how high will the Fed let Treasury yields go? Members of the Federal Open Market Committee (FOMC) have explicitly stated that they want to keep yields and interest rates low to help spur economic growth. As you can see in Figure 4, the Fed has been quite good at keeping 10-year yields below 2% since Q2 2012.
The Fed could try and jawbone yields lower, but if tapering concerns continue to heat up, it could be a rocky ride for the stock market.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.