Rational and Irrational Fears Over Fed’s QE Tapering Process

Some people say that markets are fundamentally irrational others and others that there are always good reasons underlying any major movement.

I prefer to think in terms of a constantly changing cocktail of rationality and irrationality, which might even be described as 'irrational rationality' and 'rational irrationality'.

It seems that for the last two months rationality and irrationality have been fighting it out in highly unsettled markets.

Federal Reserve Chairman Ben Bernanke's testimony to the Joint Economic Committee of Congress on 22 May is widely thought to have sparked the sell-off but, in fact, it had started two weeks earlier in the bond market as investors began to face up to the reality that yields could not go any lower than the levels touched in a last hurrah in April.

The dollar, which had been moving higher vs. the yen and gold since October, started to climb against most other currencies.

With hindsight, the few hours following Bernanke's testimony was when sentiment towards equities changed, despite his insistence that he was keeping open the option to increase the level of monthly asset purchases as well as holding or reducing it.

Investors, especially those engaged in carry trades out of the US into Emerging Markets, decided that the game was up for them.

Goldilocks scenario be damned: it was more like 'cry havoc and let slip the dogs of taper'. Now, at the turn of Q2 into Q3, those 'dogs' are running still.

Irrationality

Just as one had to accept the reality of Risk On-Risk Off markets, despite their mindlessness, there is no point in ignoring the fact that most investors, especially in the US, are dismayed at the prospect of the FOMC's first tapering and then ending the QE 3 asset purchase programme. The dismay seems fuelled by at least three major fears:

Bond yields will rise uncontrollably fast to choke off growth in the US and emerging markets (it is already choked off elsewhere).

The Bank of Japan's $1.5tn QE programme, which is only just cranking up, will fail to make any difference to global liquidity even as at least a partial replacement for the Federal Open Market Committee (FOMC) programme.

Slower growth in emerging markets is just as harmful to the US economy as no growth at all

These fears seem excessive unless placed in the context of the carry trade: massive (but, sadly, unquantifiable) borrowing of cheap dollars to fund investment in just about anything that might be expected to go up in value.

The fears are further heightened for those who do not believe that Bernanke (who is in any case looks set to retire in January) or his colleagues are capable of managing an orderly tapering process. For them, he has unleashed the most dread 'dog' of uncertainty.

Then there are others who simply do not believe the carefully chosen words in FOMC statements and minutes: they point to the obvious differences between the Committee's participants and conclude that Bernanke and his core supporters are in a hurry to end all purchases before the end of 2014, no matter what.

Rationality

What if one reads Bernanke's lips and believes him and his core supporters on the FOMC?

Even some of his less obviously committed colleagues have joined in the recent barrage of assurances to investors.

In an interesting side-show, Bernanke appears to have gone out of his way to snub the Kansas Fed, who's current and past Presidents, Esther George and Thomas Hoenig, have dissented on every occasion that they have been voting members of the FOMC.

The Kansas Fed hosts the annual Jackson Hole Symposium in August, which is usually attended by central bankers from around the world and Mr Bernanke has in the past used it to signal his latest thinking. Big Ben ain't going this year and has somewhat waspishly noted that the Symposium was only a regional event.

Of course, it may simply suit him to stay out of the spotlight until his press conference immediately after the FOMC's meeting on 17-18th September. There is another Committee meeting before then on 30-31st July but there will be no new economic projections prepared, nor a press conference.

All in all, it seems beyond doubt that increases in official interest rates are still not going to happen until 2015.

It also seems safer to accept that the pace of tapering will be tempered by progress in the US economy and this should offer comfort to the meek. Then there are the counterblasts to the irrational fears described above:

Bond yields had to turn sooner or later. They could not have got much lower and were becoming increasingly detached from credit risk, both political and commercial.

Some sort of correction for equities is really quite healthy after such a strong run that began last summer (catching out those waiting for St Leger's Day!) with blips only in October and March. It provides the opportunity to assess calmly where the best buys may be.

The BoJ's QE programme simply must contribute to global liquidity, if anything rather too much as the carry traders return gleefully to the yen for 'cheap' funding.

It is also worth remembering that not all the recent global economic growth has been fuelled by QE.

Bernanke has justified it many times it as a defence against recession but has never claimed that it can galvanise the economy on its own.

A majority of the UK's MPC is deeply sceptical while the ECB bigwigs are horrified by the mere thought of it.

Mind the US data

Nevertheless, Bernanke has gone out of his way to dispel any ideas that there is a similar direct link between unemployment and QE as there is with any increases in interest rates.

This is a hugely important specific qualification to his remarks on matching the level of asset purchases to the general progress of the economy.

This, together with various hints in his testimony to Congress on 22nd May, his press conference on 19th June and speeches by his colleagues, makes it clear that asset purchases will indeed be wound down. Naturally enough, everyone would like to know when tapering will begin and at what pace it will be carried out and, equally naturally, Big Ben is not going to commit himself.

For now, sticking my neck out, I would expect a cut of at least $20bn (out of $45bn) in the monthly purchases of US Treasuries after the FOMC's meeting on 17th- 18th September, with the $40bn of mortgage-backed securities to go next and the programme to finish by the end of 2014.

In the meantime, markets will be even more obsessed with the latest US economic data, as well as being on the qui vive for hints from FOMC participants. Mr Bernanke's probable departure and speculation over his successor will add to the 'fun'. (Vice Chair Janet Yellen is the current favourite and a Democrat but President Barack Obama may be unable to resist appointing Larry Summers to 'stick it' to the GOP).

Last week's numbers provided further confirmation of the continuing recovery in the consumer and housing sectors but the Chicago PMI was sharply lower again after bouncing back in May and added to the sequence of erratic and mixed data from the business sector.

The downwards revision of Q1 GDP came as a bit of a surprise but, of course, in the current topsy turvy mood helped equities and bonds to edge higher.

'Bad' news is apparently 'good' in most markets in that it may postpone the dreaded tapering.

Next week brings the important ISM surveys and on Friday the Non-Farm Payrolls: they should all be solid enough but perhaps not quite good enough yet to convince everyone that tapering will start in September. The need not to be caught out by the Independence Day holiday may exacerbate any jitters. We had all better get used to a period of investor skittishness and price volatility whenever the next major US data announcement looms.

Alastair Winter is the Chief Economist at Daniel Stewart & Co