The Tale of the Taper

It is apparent now more than ever just how much US monetary policy affects the rest of the world. The Fed has been printing $85bn a month, half of which buys government treasuries with the rest going towards mortgage-backed securities. If you read my last blog, you will understand that this unconventional monetary policy is called quantitative easing (QE). Whereas most central banks have adopted QE, none have quite had the same far-reaching effects that the Fed’s QE3 has had on the global economy.  A minor change in US policy can lead to global catastrophic effects.

In May, Ben Bernanke, the head of the Federal Reserve, outlined that they would begin to “taper” their QE3 programme in the coming months in response to positive US economic data. Little did he know the ramifications that statement would have. Tapering involves reducing the amount of money that the Fed will print each month, not to be confused with stopping the policy altogether. In fact, following his remarks, the markets predicted that he would reduce QE from $85bn to around $70bn by September’s meeting. This widely accepted expectation lead to huge knock on effects.

Most obviously, bond yields soared as expectations of future interest rates increased. To understand this, you must know that bond yields move inversely to their price. If the Fed were to reduce demand for US treasuries then their price would fall and subsequently yields would rise. The expectation of this and higher future interest rates pushed up yields on longer-term products. In fact 10-year government bonds jumped a full percentage point following Bernanke’s revelation, and not just in the US.  As yields rose, bond prices fell hurting those with a large portfolio of fixed income products, wiping away large amounts of capital.

Then there was the "Emerging Market Summer Sell-Off". The anticipation of less liquidity due to tapering and improved returns in the developed world, lead investors to begin to pull out capital from emerging markets. The hardest hit were India, Indonesia and Turkey. Loose monetary policy in the US lead to huge capital inflows into these economies over the past few years. As investors began to pull out of these emerging markets, their currencies began to tumble. With large current account deficits, the central banks had to start eating into their reserves to prop up the currency. In fact, Raghuram Rajan, the newly elected head of India’s central bank, decided to increase interest rates last week to protect its currency. These economies rely heavily on huge capital inflows to fund their deficits, so the news of a potential tapering was a disaster.

There have been a number of other consequences. The stock market has been volatile. Bulls will say that tapering indicates the US economy is on a upward growth trend whereas Bears will argue that any monetary tightening is too early and would upset equities. As a result, risk appetite has fluctuated according to investor confidence and the expectation of when the tapering will begin. That said, the news of a taper has not prevented a surge of M&A activity, including the third largest acqusition ever between Vodafone and Verizon Wireless for $130bn.

Gold has also fallen dramatically over the last few months as people move into riskier assets and thanks to an expectation of a dollar increase (due to less tapering).

The most important thing to note is that all this happened before tapering had even started. Everyone was pricing in a taper before it had happened. So it surprised the majority of the financial world this September when Bernanke decided not to taper.

Even though US unemployment had fallen to 7.3%, closing in on Bernanke’s 7% target of completing the taper entirely and the 6.5% US target of increasing the Fed Funds rate, the Fed decided to stick with $85bn per month. The explanation was three-fold even though it was made clear that it was a ‘borderline’ decision. Firstly the reaction in and of itself was enough to suggest that the US economy was not ready for a taper. Secondly, the data was not as convincing as first glances suggest. Although unemployment had fallen in the US, this is mainly thanks to a disastrously low participation rate; it’s lowest for decades. Lastly, the US still needs to sort out the mess with its debt ceiling. If Congress does not reach an agreement on increasing the debt level, the government may have to shut down all non-essential activity in October. Although very unlikely, Bernanke was implicitly keeping monetary policy loose in case of a severe fiscal tightening in the coming months.

So was he right? Yes and No.

It certainly benefited the emerging economies. The news of no taper stemmed the flow of capital flying out of emerging markets and helped bolster their currencies. They now have a window of time to correct the imbalances in their economies before the inevitable repeats itself. Furthermore, a potential taper spooked markets and Bernanke is correct that there is no need to rush monetary policy tightening, especially when inflation lies below 2%. It would be a shame to damage the long-awaited return to growth with a premature increase in interest rates. Lastly, the housing market is at the centre of the US growth trend. An increase in rates will only damage this growth. Following the announcement, the S&P 500 shot up suggesting investors were delighted with the decision to keep money ultra-cheap.

However, the flipside is that everything had already been priced in. Bond yields had shot up, the stock market was positioned ready for a taper and currencies had moved accordingly. There is a strong argument to say that the consequences of a taper had already been felt and the actual tapering was just a formality. Furthermore, its important to realise that tapering is not monetary tightening. Reducing $85bn to $70bn is simply less monetary loosening. So given that the US is now growing and unemployment falling, it certainly seemed the time to slow the stimulus down even slightly.

However, the most important factor for me is central bank trust.  A key tool for a central bank is being able to communicate with markets. Markets must trust central bankers and believe their promises. It is now very unlikely that QE3 will be fully wound up by the time unemployment hits 7%. This makes the central banker’s communications far less credible. If they never stick to their plan, what’s the point of listening in the first place?

Furthermore, the early stock market gains were quickly subdued as investors began once again to argue over when tapering will actually happen. The fact that the Fed decided not to taper also dampened investor confidence in the US growth trajectory pushing a lot of people back into safer assets such as government bonds. In effect, good news quickly became bad news.

So markets are still left volatile and the process begins again for the October meeting. The new expectation is that tapering will begin in December but the herd was wrong last time. I believe that the markets were prepared for a September taper, which had already been priced in. The only thing not tapering has done is attach a large amount of unpredictability to the central bank.