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2013Q3 - Pacifica Newsletter - Taper Tantrum

2013Q3 - Pacifica Newsletter - Taper Tantrum

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Tapering Stimulus: Equity markets
have been spooked by the Fed’s recent call to rein in bond purchases. Markets are reluctant to see any stimulus withdrawal.

Limits to Policy: Although the recovery
in the US is underway, unemployment remains stubborn. This is a key factor to watch going forward.

Europe & China: Europe may have
passed the worst of its decline while China’s data continues to show weakness.
Tapering Stimulus: Equity markets
have been spooked by the Fed’s recent call to rein in bond purchases. Markets are reluctant to see any stimulus withdrawal.

Limits to Policy: Although the recovery
in the US is underway, unemployment remains stubborn. This is a key factor to watch going forward.

Europe & China: Europe may have
passed the worst of its decline while China’s data continues to show weakness.

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Categories:Types, Business/Law
Published by: Pacifica Partners Capital Management on Aug 06, 2013
Copyright:Attribution Non-commercial


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Tel (604) 576
Quarterly Commentary
Investors Throw a “Taper” Tantrum
In This Issue:
Tapering Stimulus:
Equity marketshave been spooked by the Fed’s recent call torein in bond purchases. Markets are reluctant tosee any stimulus withdrawal.
Limits to Policy:
 Although the recoveryin the US is underway, unemployment remainsstubborn. This is a key factor to watch going for-ward.
Europe & China:
Europe may havepassed the worst of its decline while China’s da-ta continues to show weakness.
he financial industry rarely has a challengewhen coming up with clever head-lines to describe the markets. Our news-letter gets its title from recent investor re-action to the mere hint that the US Feder-al Reserve (the ‘Fed’) may reduce or ‘taper’ its monthly $85 billion bond pur-chase program. Since bond prices andinterest rates move in opposite directions,investors have taken great comfort in Fedbond purchases since they have providedfuel for financial markets while at the same timekeeping interest rates anchored near generationallows.The reason that the Federal Reserve’s bond buyingis so important to the markets can be seen by look-ing at how the Fed impacts the financial system.When the central bank buys bonds it is hoping thatthe sellers reinvest the proceeds of their bond salesinto the financial markets. As these funds are chan-neled into these markets, the prices of financial as-sets such as stocks and bonds are expected torise which will then create a “wealth effect”. The“wealth effect”, according to economists, is the ideathat when individuals feel wealthier due to an in-crease in the value of their assets they will spendmore. Thus, the Federal Reserve is wagering onthe idea that rising asset prices would help higher spending to take root. This would in theory lead to aboost in economic output and eventu-ally jobs.
That is the theoretical concept and tobe fair, the low interest rate environ-ment which the Fed has helped to cre-ate has helped the recovery in US realestate. In addition, the US auto indus-try has powered up and automobileproduction has rebounded strongly.These vital segments of the US economy are espe-cially important because they are able to generateso many spinoff jobs.
Continued on page 2
Summer 2013
The US Fed buys USbonds to keep bondprices high. This ac-tion has helped tokeep interest ratesat generational lows.
Tapering Stimulus
pg 2
Continued from page 1
Stimulus Addiction
 As of the first quarter of 2013, the world’s centralbanks had injected over $12 trillion of stimulus intotheir respective economies since the start of the glob-al financial crisis. This is in addition to cutting inter-est rates to near generational lows. Markets havenow become accustomed, if not reliant, on accommo-dative monetary policy.This reliance became apparent through investors’reaction to even the hint of stimulus tapering. On May22
, the head of the US Federal Reserve, BenBernanke, told Congress that the central bank mightwind down its monetary easing stance. The re-sponse: equities around the world sold off and inter-est rates rose quickly.Of course, this reaction was not contained to the US.Interest rates were impacted throughout the world. InNorth America, mortgage rates have moved up quick-ly and some observers say it is already impacting USreal estate sales. As the chart above shows, the“taper tantrum”
caused the US 30 year mortgage rateto rise by 1.15% in a two month period and mortgagerefinancing activity simultaneously fell by more than50%.Offsetting this interest rate spike is the fact that homeaffordability in the US remains comfortably above his-toric levels.
The reaction from the markets was so quick andstrong that the Federal Reserve attempted to walkback the earlier comments and go out of its way toclarify what Bernanke meant to say. It should be not-ed that the minutes from recent Fed meetings revealthat Bernanke was not alone and had support fromother Fed governors to begin trimming monetary stim-ulus if necessary.
What Bernanke actually said according to the tran-scripts from the Federal Reserve is that the improvinglabor markets and the expected gradual rise in infla-tion towards its targeted two percent rate would dic-tate further policy ac-tions such that,
“… if the subsequent data remain broadly aligned with our cur-rent expecta-tions…,we would con-tinue to reduce the pace of purchases inmeasured stepsthrough the first half of next year.” 
If that were notenough to make themarkets to perhapsrethink their reaction,Bernanke also stated that he wanted to
“… empha-size once more the point that our policy is in no way  predetermined and will depend on the incoming dataand the evolution of the outlook.” 
In short, the Fed willlook at the data and decide the appropriate course of action in the future.
Perhaps the most important variable in determiningFed policy will be US jobs data. Even the traditionalmain focus of inflation will likely play second fiddle tothe unemployment rate. As the chart on page 3 shows, the US economy hasbeen able to add over 7 million jobs over the last 40months. Although this might sound impressive atfirst, the job additions work out to less than 200,000 jobs per month. To put this into perspective, the USeconomy needs to generate about 350,000 jobs per month to keep up with the growth of the labor force
Continued on page 3
Chart Source: FactSet
pg 3
Continued from page 2
and to keep the unemployment rate on a downwardtrend. Also disguised in recent US labor data is the soberingfact that the number of US workers with part
time jobswho have indicated that they would prefer a full
timeposition if possible sits at 8.2 million – the highest ineight months. In comparison, 11.8 million Americansare “unemployed”.
It bears clarifying that the official unemployment ratedoes not take into account individuals who havesimply given up looking for work or are unable tosearch for work for various reasons. These individu-als total an additional 2.6 million.
 Although the unemployment data is humbling to poli-cy makers, on a positive note, wages have begun toturn up and the average work week has also beenimproving since the recession ended.
Policy Limits
On the one hand markets are dread-ing the day the Fed eases back on itsstimulus, yet on the other, the Fed’spolicies have not been effective for the millions of people looking for fulltime employment. The job creationgap is putting a spotlight on the limitsof monetary policy.Equally frustrating for the Federal Re-serve is that despite injecting trillionsof dollars of capital into the US bank-ing system the lack of credit creationfrom banks has been lacklustre.Simply put, banks aren’t lendingenough and households and busi-nesses are reluctant to take on debt.In some ways this amounts to a fail-ure by businesses and consumers to take sufficientadvantage of the Fed’s current generosity.
Growth in bank lending is a vital element for the Fed’sefforts to succeed. Ultimately, every bond purchaseby the Fed ends up increasing the bond seller’s bankreserves. Reserves are the amount that a bank canlend out. Historically, as excess reserves were lentout by the US banking system, each dollar of re-serves created by the Federal Reserve amounted toabout a $70 increase in the money supply. However,after the financial crisis, this has dropped to only ameager $1.50 increase in the money supply. A risingmoney supply acts as a source of energy for the econ-omy. The excess reserves that are not being bor-rowed by consumers and businesses (lent by banks)is now approaching a staggering $2 trillion.
Financial markets may be able to handle a stimulusexit if the global economy can continue to grow at a
pace of ‘’not too hot and not too cold’’. Insuch a scenario, bond markets will be relieved that thepace of tapering will be gradual. Meanwhile equitymarkets may hope to offset the gradual drag of higher borrowing costs through a slow and steady rise in cor-porate earnings.Unfortunately, second quarter 2013 reported earningsare not too spectacular. Sales growth is coming in atthe lighter end of expectations and companies are in-dicating global challenges remain. These challengesarise from Europe continuing their austerity and debtstruggles, China and India showing slowing economicgrowth and Brazil – the engine of Latin America —floundering with a bout of rising inflation and slowingeconomic growth. Brazil’s economic challenges canbe highlighted by the fact that the consensus forecastfor Brazil’s economy calls
Continued on page 4
Chart Source: Market Watch, US Department of Labor 

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