Training wheels

The Federal Reserve took the training wheels off the economy this week. 

You may remember waddling around a front yard or path with training wheels affixed to the hub of your bicycle’s rear wheel. Like most small children, you lacked the balance or strength to keep a bike upright on your own.

Once you reached a certain age or size, your need for those awkward little plastic wheels began to diminish. Whoever taught you to ride removed them, forcing you to balance and steer on your own. Before you did so, however, perhaps they guided you through your first rides on a two wheeler – placing one hand on your back, the other on the handlebar – walking you slowly around the yard and urging you to peddle faster before they let go. Eventually you learned to bring the bike to a speed that eased your awkward balance.

Which brings us to tapering.

The Federal Reserve took the training wheels off the economy this week with its decision to reduce monthly Treasury and mortgage-backed security purchases to $75 billion, a small but meaningful reduction of the $85 billion in purchases it oversaw for each of the last 15 months (not counting previous rounds of quantitative easing). Although this marks a significant step towards normalization, make no mistake: the central bank’s tapering plans allow it to maintain a firm grip on the economy’s handlebars for the foreseeable future. 

For good reason, the Fed’s quantitative easing programme has been a critical element of the economic recovery. When it first announced its intention to eventually taper asset purchases on 19 June, citing improved resilience of the US economy and labor market, five year treasury yields spiked from 1.07 percent on Wednesday to 1.34 percent in a two day stretch.

The spike in yield curves corresponded with a massive reduction in high yield issuance for the month, which fell to just $12 billion in June.

The latter point is particularly important. Quantitative easing plays a vital role in keeping interest rates at basement levels, which led yield-seeking investors to invest in the high yield markets at record levels. Investor interest, in turn, facilitated the wave of refinancings that provided the bulk of this year’s deal activity. Given the lack of M&A, this was a welcome development for the private debt industry.  

The response to tapering this time around has been comparatively measured. Though substantial, five year treasury yields had only jumped from 1.52 percent Tuesday to 1.63 percent by market close on Thursday. As for high yield issuance, despite the widely held belief that tapering would commence by year end, the US still managed to top $19 billion through the first two weeks of December

In essence, the measured approach elicited only a moderate response from the market, something that should ease concerns as the Fed continues to taper through 2014. By mellowing the pace at which it reduces its asset purchases, the Fed is slowly returning control of the economy to its participants. It's a prudent approach. The wheels are off, but a guiding hand is still there to prevent it from crashing.  

Slowing the pace of tapering should give the economy a chance at a stronger, more lasting economy. Here’s hoping investors continue to respond in kind.

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