If Bernanke Doesn't Taper, Yields Will Force Him

Since Wednesday's highly anticipated FOMC meeting, the major stock indexes have soared. As you all know, the Federal Reserve said that it will continue its $85-billion-a-month QE-3 program. The current QE-3 program is where the central bank buys $45 billion in mortgage backed securities (MBS) and another $40 billion in U.S. Treasuries every month. The Federal Reserve also has the fed funds rate at zero to a quarter percent, it has been at that level since December 2008.

Bubbles
So what will cause the Federal Reserve to taper the current QE-3 program? Obviously, the central bank tells us that there is very little inflation in the economy, so there is really no danger to having the QE-3 program in place. History has told us that prolonged stimulus has resulted in high inflation or some type of bubble. In 2001, the former Federal Reserve chairman Alan Greenspan lowered the fed funds rate to 1.0 percent and that lead the stock market to new all time highs. Unfortunately, it also lead to the largest housing and credit bubble in seventy years. Could there be another bubble being created at this time? Or is this time different? After all, almost every central bank is following the lead of the Federal Reserve when it comes to easy money policies. The Bank of England, Bank of Japan, and many other central banks are all creating money out of thin air so perhaps this time it is different.

Rising Yields
Recently, yields on the 10-year U.S. Treasury Note have climbed sharply higher. Today, the yield on the 10-year U.S. Treasury Note is around 2.67 percent. While this is still a very low yield it should be noted that it has spiked higher by more than 1.25 percent since bottoming in July 2012. The yield chart of the 10-year U.S. Treasury note is signaling a move to 3.0 percent in the near term, so it would be prudent to expect bond prices to continue to fall. Yields are moving higher despite the Federal Reserve buying $40 billion a month in U.S. Treasuries. Is the bond market trying to tell us something? There is an old saying on Wall Street that the bond market is smarter than the stock market. You see, the people that run the bond market have much more capital than the people that buy stocks. Remember the old saying, follow the money.

If the bond market is moving higher, it is telling us that the Federal Reserve is going to need to taper itseasing program very soon. If it does not taper soon, the Fed is risking another bubble or, perhaps, massive inflation. The Federal Reserve's balance sheet is now around the $4 trillion level, so perhaps that is the next bubble to burst. Either way, everyone should keep an eye on the bond market as it always tells us what is really happening before it does.