The Fed Taper: When Not If
Does anyone actually believe the market pundits claiming that inflation is transitory and rates will stay low for years?
The Fed is determined to continue forward with its massive injection of liquidity, by keeping short rates near zero and buying $120 billion in Treasury securities and mortgages per month.* The torrid rate of bond buying over the last decade is unprecedented in U.S. history, and has ballooned the Fed’s balance sheet to approximately $8 Trillion today, up approximately 800% since 2008.
Is The Market Ignoring the Long Term?
Market participants that expect endless low rates and low inflation are seemingly ignoring warning signs in Federal debt, accelerating GDP growth, current surging inflation and financial market operational hiccups.
At the end of May, the total U.S. Federal debt outstanding was $28.2 trillion, a massive increase of $17.6 trillion over the approximate $10.6 billion level at the beginning of 2009, before the Fed started its first QE activities.** This debt level is also set to rise as the recently passed stimulus and relief bills are spent, and an additional infrastructure bill is likely to pass in the near to medium term, both of which are contributing to the estimated $2.3 trillion U.S. spending deficit in 2021.***
The current inflation data has reached its ‘running hot’ goal as set by the Fed, as the Fed’s June projection raised its 2021 median inflation target from 2.4% to 3.4% concurrent with raising its 2021 real GDP growth projection from 6.5% to 7.0%. Year over year CPI was reported at 5% for May, the highest level since 2008, while U.S. Y/Y PPI was a scorching 6.6% for May.****
Moreover, low rates and Fed buying are starting to cause real hiccups in the daily operation of credit markets, as on June 9th, the Fed’s overnight repo program was used by a record 59 participants for a whopping $502.9 billion. Banks and other financial institutions, still hampered by regulatory capital constraints and surging consumer liquidity, have been forced to use this facility of last resort, even though it is at a zero percent rate.*****
We find it hard to envision a long-term scenario where the excess supply of U.S. debt and building credit market dislocations do not drive-up interest rates to attract buyers of U.S. treasuries, or a scenario where inflation rapidly cools while the Fed continues to pump stimulus into the accelerating economic recovery.
How Do You Think About Risk?
Our philosophy is to view time as our ally when it comes to risk control. As such, we currently are focusing on equities like banks, industrials and materials that should benefit from at least the initial rounds of inflation and higher rates. Conversely, we see great risk in the expensive growth stocks, where valuations are primarily set off discounted cash flow models that are incorporating low interest rates indefinitely. Surging U.S. debt and accelerating inflation, in our view, will likely lead the Fed to taper its bond buying, which itself is at an unstainable level. We view this tapering as a coming “When, Not If”, and are positioning for this move with time as our ally.
It Matters When It Matters
When the Fed initially moves to taper, we think the market will react quickly, moving away from large overvalued growth names, to smaller cap value names that can benefit from higher inflation and rates. In our view, the time to reposition one’s portfolio for this move is now, before the market stampede when it matters.
*Fed June 2021 Press Release
**US Treasury Total Public Debt Outstanding sourced from the U.S. Treasury via Bloomberg.
***U.S. CBO forecast, March 2021: https://www.cbo.gov/system/files/2021-03/56996-budget-outlook.pdf
**** Fed June 2021 Summary of Economic Projections https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20210616.pdf and U.S. CPI Urban Consumers year-over-year reported by Bureau of Labor Statistics and U.S. PPI Final Demand Y/Y SA reported by Bureau of Labor Statistics, both source via Bloomberg.
*****6/9/21 Bloomberg Article “Fed Reverse Repo Use Tops Half A Trillion Dollars for First Time, by Alexandra Harris. Reverse repo rate raised from zero to 0.05% by Fed on 6/16/21, see Fed release above.