Is the Fed losing control of the yield curve?

This morning (8/20) Treasuries are getting a bounce after a steep sell off over the past few days.  The market is jittery before the Fed releases the July 31st FOMC, looking for any clues as to whether the central bank will commence the tapering of asset purchases. 

The consensus on the street is not "if" the tapering will commence but "when".  And it is this consensus that has roiled markets over the past week.  Particularly hard hit have been Emerging Markets and their currencies as concerns mount about whether they will be able to finance their current account deficits in a rising rate environment. 

The debate rages regarding why rates have been rising.  Some, like economist Scott Grannis, argue here http://scottgrannis.blogspot.com/2013/08/three-cheers-for-higher-yields.html that rising rates we are presently experiencing are the normal result of an improving economy and not because of market fears that tapering will slow the economy. 

It's difficult taking an opposing position to Scott as he's been "spot on" on every position he has taken since the market bottom in 2009.  Nevertheless, my concerns surround the rate of increase in rates since May 1st.  Below is a daily line chart of the Ten Year US Treasury yield since September, 2008:

(click on chart for larger image)

 

I want my readers to get a sense of where we've been in the past five years since the dark days when Lehman Brothers imploded and the global financial system froze.  As an aside, everyone looks at those dark days in 2008 as a very dangerous time (and they were) but often ignore the fact that the bond market was telling them that July, 2012 was an even more dangerous time (ie. Credit Anstalt 1931 redux). 

 

 

For the purpose of illustrating my present concerns, look at the right side of the chart and you see the incredible spike in the Ten Year yield.  The yield has risen an incredible 127 basis points from May 1st to present.  I think Scott would have to admit that kind of ascent is not representative of an increase in yields during a normal credit cycle.  In fact, I submit that making the comparison with a normal business cycle is invalid because of central bank distortions that have skewed the credit and business cycles. 

 

 

While no one can deny that economic stats have improved over the past year there are still disinflationary concerns that I highlighted here (http://equitymaven.blogspot.com/2013/08/is-it-inflation-or-deflation.html) and here (http://equitymaven.blogspot.com/2013/08/another-reason-for-golds-decline.html ) that would negatively impact the economy by any Fed reduction in asset purchases.  Additionally, Emerging Market equity and bond markets are still reeling from just the possibility of a Fed tapering.  What will happen if/when they do announce the actual tapering?

 

 

It could be that, in anticipation of the Fed tapering, the market is actually repricing itself with the current weakness we have seen.  If so, we should see market volatility settle down after the next Fed meeting on September 17th and then a resumption of the rally.  And this would prove Scott's thesis correct. 

 

If however, my thesis is correct, the Fed will be caught in a quandary.  Recent price action suggests that Mr. Market is warning that if the Fed starts taking the "punch bowl" away, the economy is going to deteriorate.  But the Fed didn't pump two+ trillion dollars into the US economy thereby levitate risk assets only to see them falter and threaten the tepid recovery we've been experiencing.

 

If I'm right, the Fed will be caught behind a "rock and a hard place".  What will it do?  Bite the bullet and taper in order to alleviate potential inflationary pressures that are currently non existent?  Or will it acquiesce to its "spoiled child", Mr. Market, and forgo tapering?

 

I hope Scott's thesis is right ...