Why there won't be a taper tantrum this time around

and what will happen instead

There is a phrase that has been tossed around by a few in the financial news media lately. The phrase is taper tantrum and some even believe we could experience it again. What does taper tantrum even mean? The taper tantrum described the surge in yields on US treasuries during the 2013 reaction to the Fed reducing their quantitative easing policy. It wasn’t even a full on stop of the policy. It was simply going to be a reduction in the pace of its purchases of treasury bonds. The ensuing rise in yields was dubbed the taper tantrum. What was truly shocking about this era was that no sell-off of Fed assets or tapering of the Fed’s quantitative easing policy had actually occurred. Simply alluding to the intention of reducing the quantity of bond purchases spooked bond market investors enough to cause yields to rise.

We are now sitting in a similar situation. The Fed has been on a tear. They have been adding $120 billion to their balance sheet in mortgage-backed securities and US treasuries every month. Chairman Jerome Powell broke the ice in June that they would need to start thinking about, suggesting, that they should talk about, the idea, that there should be a time to reduce the asset purchases, sometime in the future. Mr Powell was very cautious in his wording. He knew he needed to bring it up and he knew it needed to be addressed but he also knew of the recent Fed history of tapering asset purchases.

Something interesting happened in the market when this was first announced. Instead of rates pausing or rising, they continued their downward trajectory.

This is completely the opposite of what happened in 2013.

Communication is a two way road. The Fed has communicated to the bond market what it is planning to do. Now the bond market is telling the Fed what is going to happen. The reaction that we are witnessing is a strong desire to hold bonds. So strong, in fact, that even a 10 year breakeven inflation rate at 2.30% won’t deter bond holders.

This is an extraordinary reaction. What the bond market is telling the Fed is that they know the Fed is in a tight spot and because of this the Fed Funds rate will need to be held at zero for a longer period of time. The Fed will be in the uncomfortable position of being forced into holding short-term interest rates below the rate of inflation. This means that future inflation expectations are higher than the return on bonds leading to negative real returns.

Why would investors tolerate this and how long could it go on for? What are the repercussions for the broader market if real interest rates are negative? Investors will tolerate this because it is believed that they have no alternative. The problem is, negative real rates will begin to weight heavily on equity valuations. In time, this will lead to a correction in the stock market. I am hopeful that the key indicators will alert me ahead of time so that I can be prepared. The place to be is SOG (silver, oil, and gold). When stock valuations fall, the bond market has negative returns, and cash is losing ground to inflation, gold will have a positive return. It will be the safe haven of last resort. We will see similar reactions in silver and oil.