The controversy over the Federal Reserve tapering its bond purchases, which are part of Quantitative Easing 3 is largely misunderstood. And now the debate may need to be reopened because the debt ceiling debate may significantly be weakening demand for U.S. Treasuries.
Let's start from the beginning. The credit crisis that peaked in 2008 was a shock to the economy that required a massive deleveraging. The bottom line was the economy stunk, which caused the Fed to lower interest rates to zero. While technically in recovery the last few years, the economy has continued to struggle and with interest rates at zero and no chance the Congress would help stimulate the economy on the fiscal side the Fed initiated quantitative easing (purchasing mortgage back securities and Treasury assets). In the last few years the Fed initiated, QE1, QE2, Operations Twist (buying longer term Treasuries as shorter-term products came up) and finally the open ended $85 billion in monthly purchases that is QE3.
This eventually needs to end and Fed Chairman Ben Bernanke made that clear this past May, which caused the bond and equity markets to go spastic. What Bernanke said is that the Fed would likely begin to lower the amount of asset purchases (Taper) before the end of the year and completely end the program by mid-2014, though it all would be dependent on economic data.
Most analysts ear marked the September Federal Open Markets Committee (FOMC) meeting as the start of tapering. All things being equal they were probably correct but the jobs numbers didn't cooperate and other issues such as concerns over a possible U.S. strike in Syria and a government shutdown and debt ceiling fight were other factors that may have given the Fed pause.
However, the prevailing wisdom was that there wasn't going to be a debt ceiling debate similar to two years ago where the fight went right up to the edge of default, arguably causing Standards & Poor's to downgrade US. Debt. Speaker of the House John Boehner (R-Ohio) was on record saying that he would not allow us to go into default. But Boehner is not in control of his caucus and we are sitting right on the edge once again.
Sorry this has taken so long but it leads up to my major point, which is, by putting the entire world through this ringer once again, we may have significantly hurt demand for U.S. assets, specifically U.S. Treasuries. The same U.S. Treasuries the Fed is planning to reduce its purchases of.
So now the Fed has to take into consideration permanent damage to demand for U.S. Treasuries as it looks to taper asset purchases. The Fed has been waiting for the recovery to gain a bit of steam, perhaps for nonfarm payrolls to sustain average monthly growth north of 200,000 jobs or thereabouts. But now it must consider the real possibility that risk managers and foreign governments throughout the world are probably looking for a way to reduce exposure to U.S. assets.
It is true the U.S. dollar is still the safest safe haven out there -- the cleanest dirty shirt as it where -- but think as a risk manager would and you probably come to the conclusion that you will want less, not more, U.S. Treasury exposure. This presents a different problem for the Fed than just delaying the taper by a meeting or two, this may require an entire recalibration of its analysis on reducing QE3.