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Analysis: The case against Fed tapering this year

Thomas H. Kee Jr., president and CEO of Stock Traders Daily
Monday, 26 Aug 2013 | 2:14 PM ET
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My observations tell me that there is virtually no chance that the Federal Reserve will taper in September and very little chance that it will taper its buying program any time through the remainder of 2013.

According to the minutes of the Federal Reserve's most recent meeting, the Open Markets Committee is respecting a timeline based on improved economic conditions, and those play an integral role in my assessment.

But in addition I have quantified not only the real net stimulus of the current bond buying program, but I have also adjusted it to reflect future influence based on the future funding needs defined by the U.S. Treasury.

Rightfully, the Fed should be talking about tapering, but the probability of satisfying the conditions Chairman Ben Bernanke set forth to taper in September or between now and the end of the year—if not throughout 2014—is extremely low.

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One of the mandates is for the unemployment rate to reach 7 percent, which is 0.4 percent lower than where it is today. Expecting a decline like that over a one-month time frame is sophomore, and my assessment suggests that it will take much longer to satisfy that requirement.

Most recently, it took seven months for the unemployment rate to fall by 0.4 percent to where it is today.

Not only do I expect the unemployment rate to remain above 7 percent in September and throughout the remainder of 2013, but also I expect this to be true throughout Bernanke's term and into 2014.

Although this article is not as focused on my longer-term macroeconomic assessments, if I included the findings of The Investment Rate I would also suggest that unemployment levels are likely to increase during 2014 rather than decline. That would prolong the tapering prospects so long as they continued to be based on the mandates set by our current Fed chairman.

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In January, we will have a new chairman and policy decisions may change, but given what I know about current mandates the likelihood for tapering is slim and it would require a drastic change to the unemployment rate.

Given the stock market's recent decline and the decimation in the bond market that has resulted from the fear imposed by the FOMC as it began to talk about tapering, if the stock and bond markets are reacting almost solely to that fear they have likely overreacted and opportunities exist in select areas.

However, my assessment also suggests that the FOMC should be tapering their bond buying program not only based on the conditions in the economy, which include bubble-like asset prices in my opinion, but also do to the lower funding requirements for 2014 as anticipated by the Treasury department.

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Using data provided directly by the Treasury we can quantify the influence of the current stimulus program and determine how much wiggle room the Federal Reserve has now to taper its bond buying program.

This analysis begins with an assessment of the influence of the current program with definitions that allow us to project the influence next year as well.

The purpose of infusing capital into the economy is to improve economic conditions, prevent deflationary risks, and initially to stabilize financial markets.

(Read more: The 5% recovery: Why most are still in recession)

With the ultimate goal of allowing the economy to grow on its own eventually, current stimulus measures have worked to improve asset prices, but underlying macroeconomic conditions suggest that the velocity of money that might normally increase along with aggressive stimulus like what we have seen recently does not exist.

Stimulus efforts like what we are witness to now can either influence the economy by purely infusing capital into the system or by increasing the velocity of money within the system. But because the velocity of money in our current environment is so low we can reasonably conclude that the main influence of the current FOMC stimulus policy is to infuse capital.

Therefore, identifying the actual capital infusions into the financial system is critical when quantifying the effect of tapering.

According to my assessments, which are based on a combination of Treasury action and FOMC stimulus, with adjustments for foreign interest in Treasury bonds, the domestic net stimulus from our current $85 billion monthly bond-buying program is only about $16 billion per month.

Review of the equation below to extrapolate this detail.

FOMC stimulus -((Treasury Issuance - refunding) X (foreign interest inverse multiplier))

Given the equation above, the current $85 billion monthly capital infusions into the financial system of the United States is offset by $68.91 billion per month in domestic treasury operations.

Our current factor for foreign interest is 15 percent, but foreign interest in U.S. treasury bonds has been declining steadily from recent highs near 30 percent.

(Read more: Here's what economists say is US' biggest worry)

Although foreign interest in U.S. Treasury bonds could remain immediately weak, my assessments also suggest that foreign interest should increase going forward. I am expecting foreign interest of 20 percent or more in calendar 2014.

An adjustment for foreign interest is one difference between the current influence of monetary stimulus and our evaluation of the future influence of monetary stimulus, the second being the reduced funding demands indicated by the U.S. Treasury for 2014.

According to the Department of the Treasury funding requirements decline by 23 percent in calendar 2014 from what they were in 2013, and as a result the U.S. Treasury expects to issue far fewer bonds in 2014 than it did in 2013. This is a critical component in a major influence in this assessment.

Given these adjustments for 2014, the equation above suggests that if the FOMC continued with their $85 billion monthly capital infusion, instead of infusing $16 billion per month into the US economy, it would be infusing $35.4 billion per month given the reduced demand indicated by the Department of the treasury.

If the FOMC continues on its current pace without tapering its bond buying program it will actually increase real net stimulus by $19.4 billion per month.

This quantified observation offers three real conclusions: the first is that the current $85 billion monthly program will become much more stimulative if nothing changes.

The second is that the FOMC could taper by about $20 billion without changing the real net stimulus to the US economy.

(Read more: Is 'chaos' ahead? Some truths about Fed policy)

And the third, the FOMC could taper by $35.4 billion before the combined efforts of the U.S. Treasury and Federal Reserve become a drain on liquidity.

In summary, not only is the FOMC highly unlikely to taper its bond buying program given the economic mandates imposed by Ben Bernanke and the support for those mandates that the governors offered, but also whenever tapering actually begins the Federal Reserve has a tremendous amount of wiggle room given the reduced funding requirements indicated by the Department of the Treasury.

These observations serve to suggest that the fear of tapering is overhyped and we expect this fear to be reversed out of the market going forward.

This will not change our earnings assessments or our macroeconomic assessments, but it does play a material role in market sentiment.

—Thomas H Kee Jr. is president and CEO of Stock Traders Daily and author of Top of the Market to You!

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