By: Tim Marting
Tapering oh Tapering..
What does this mean and is it good for today’s investor?
To figure this out we have to dissect exactly what it means when Powell said tapering won’t begin for a bit longer depending on market conditions.
So.. What is tapering?
Simple. Tapering is the gradual reversal of a quantitative easing policy implemented by a central bank to stimulate economic growth.
….uhh what? Maybe not so simple… Let’s dive into this a bit more.
To spur growth for the economy and negate the effects of covid as quickly as possible, the Fed is doing something it tried in 2008. Slash rates and “print” money. When the Fed cuts rates to near all-time low’s, it has to as well implement quantitative easing solely because cutting the rates itself isn’t as effective as it used to be.
…uhh what? Let’s dive into this a bit more.
Interest rates -which is what the fed is cutting- is a tool the fed can use to try to get banks to lend to each other. Essentially, when the Fed lowers interest rates to 0-.25% -as they did back in 2008 and are currently doing- they are declaring that for banks to loan money to each other, it will cost them 0-.25%, which is practically nothing.
For a simplistic example, for every $100.00 banks borrow, they have to pay back around $100.00 - $100.25. AKA banks are incentivized to borrow more -because banks should be able to borrow practically free money (0-.25%) and make more off their investments (lending to average joes for one example)- which should ideally spur economic growth.
Now, when the interest rates are so low and banks are STILL holding their money (I’ll explain why they're still holding their money below), the Fed then has to use another tool to try to spur economic growth; enter quantitative easing. Where interest rates impact the price of money in the market (you borrow $100.00 and you eventually have to pay $100.25) they now have turned to quantitative easing, which impacts the quantity or amount of money in the market.
There is where it gets fun… if you like going to the casino kind of fun, in my personal opinion. But hey… I like going to the casino, I just don’t like my government going to the casino, because surprise… the house ALWAYS WINS.
Anyways, let's dissect exactly what is going on here.
When the interest rates are dropped to all-time lows, the government is hoping the banks will turn around and lend that super cheap money to the average joe, who desperately needs that money for his/her business. While the bank can loan to average joes at 5-10% interest (aka a fantastic return) the risk to loan that borrowed money to average joes is too great a risk in the bank’s eyes, considering Peter (poorly inserted dodgeball joke) isn’t always a safe bet to pay that money back in 10-15-30 years, because his business might not make it.
We all know banks just don’t care about the average joe because the average joe is risky. So, they instead look at a safer bet. Enter that thing you probably hear about all the time but might not understand... 10-year treasuries. Why do they do this? Because while the banks can practically get free money that is intended to go to the risky average joes to spur the economy, the banks don’t want that added risk, so they buy up 10-year treasuries that have the wonderful backing of the US government (aka just about as risk free as money gets). While the banks might only be getting 1-2% return - which is terrible - banks like the fact that they’re getting some return, even if that return is less than inflation. BUUUTTTT towards the lower end of that return (1%) banks begin to decide if that’s enough to combat inflation… oh inflation you beautiful thing.
NOW enter quantitative easing. This is where the government “prints” a bunch of money to create inflation while buying the risky defaulting assets of the bank as well as buying “their own” 10-year treasuries (going to the casino).
Now why the actual BLEEP would the government buy crap debt from banks AND their own 10-year securities that they know won’t beat inflation - you know, the inflation that they themselves are intentionally creating. Well, so those a-whole (lot of nice people we refer to as) bankers will lend money to the average joe.
1. By buying bankers bad debt, the banks are more inclined to take a risk on the average joe because their riskier assets have been taken off their balance sheet by the Fed purchasing them.
2. By purchasing 10-year treasuries it creates more demand for the 10-year treasuries. When demand for the treasuries rise, the lower the yield will become. --- If everyone bought treasuries at 5% and the US government never changed the rate, they wouldn’t be able to pay off everyone at 5% in 10 years or they’d most likely default on their debt or print so much money inflation would have a hay day. They then have to lower it proportionally to the amount of people buying the 10-year treasuries --- SOOO this means that the banks that were buying 10-year treasuries that were returning 2% are now returning 1-ish% and they aren’t as attractive. With less risk on their balance sheets and no great risk-free return they have no place else to go than to the stock market, average joes, or alternative investments.
This is why all the hype is surrounded on the 10-year treasuries, because the higher the rate, the more likely the banks will stop lending to average joe.
Enter the casino bit.. If the Fed does this for too long, we have some form of hyper-inflation. If they stop it too early, it could lead to a recession… tightened money/lending for the average joe.
Hopefully this gives you a better idea on how the connection of rising yields scares institutional investors as well as why tapering is such an important topic in the financial community. Hopefully the two attached links below (which I would recommend reading, after you understand a bit more about tapering now) make sense.
** I always recommend getting news from sources all around the world. I do this with a VPN which I highly recommend everyone get. Also, privacy is a great thing. **
If you’re thinking like you should be… you’re probably questioning that beautiful thing called “transitory inflation” which I will explain in my next article.
If you’re interested in that article. I’ll post it sometime next week and attach a link here.
Happy days,
Hugh