The crack that opened up in financial markets earlier this week after Ben Bernanke set out the US Federal Reserve’s plans for its preferred pathway for an exit from its quantitative easing program is developing into a rather large fissure of disturbingly uncertain depth.
The savage and broadly-based sell-off in financial markets overnight, which continued into the Australian currency, bond and equities market today, is a very direct and brutal response to Bernanke’s statements in the US on Wednesday, when he suggested that the "tapering" of the QE III program of $US85 billion a month of bond and mortgage buying would begin later this year and be completed by the middle of 2014.
Despite Bernanke making it clear that the Fed’s policy stance would remain expansive well beyond that point – it wouldn’t shift official interest from their current near-zero levels until 2015 or 2016 and had no present intention of selling any of the trillions of dollars of securities it has bought under the quantitative easing programs – investors have rushed for the markets’ exit doors.
That response shouldn’t have surprised anyone, despite the leisurely timetable for withdrawing the Fed’s extraordinary measures and Bernanke’s commitment to dialling up or down the QE III program in response to US economic developments.
Since 2008 and the financial crisis central banks in the major developed economies have pumped an astonishing amount of near-costless liquidity into global markets in their attempts to regenerate a modicum of economic growth in their recessed economies and to avoid another crisis. There are estimates that as much as $US10 trillion of ultra-cheap liquidity has been injected into the global economy since the 2008 crisis.
That liquidity had to find a home or homes and was, in effect, deliberately encouraged to pursue risk. And it did. It poured into emerging and developed market debt and equities, into commodities, into junk bonds and generally into anything that generated a positive yield differential.
It pushed up the value of currencies and stocks and bonds in economies that offered those positive yields – like Australia, New Zealand, Brazil, Mexico and developing countries within Asia. It even pushed down the yields in the deeply troubled economies in southern Europe, creating an illusion of restored stability. Junks bond yields in the US fell to historic lows, priced as if they were investment grade.
The assumption underpinning the multitude of leveraged carry trades pursuing those positive yield differentials was that with Europe in recession and its banks and sovereigns still extremely vulnerable, and the US recovery anaemic and fragile with its growth potential constrained by US fiscal policies, these unconventional monetary policies would remain in place for years to come.
That assumption wasn’t really challenged by Bernanke’s statements – it will be two or three years before the Fed begins moving the federal funds rate from its current target range of 0-0.25 per cent if all goes according to plan – but his comments still triggered a panicked response.
It’s not that hard to understand why.
A year ago the ASX200 index was at about 4000. When it peaked last month it was around 5200 – 30 per cent higher. The US market had a very similar experience. The torrent of liquidity inflated almost all markets where there was a positive carry to the point where it is arguable it generated a series of asset price bubbles.
Those executing the carry trades would have been well aware that they weren’t ultimately sustainable and were laden with risk, but thought they had plenty of time to exit them before the monetary policy spigots started turning off.
The problem is that there is so much risk money out there in markets based on cheap debt that no-one would want to risk leaving their trades in place too long.
Markets generally act pre-emptively and despite Bernanke’s attempts to reassure them that US monetary policy would remain expansionary for some years to come it triggered a rush to unwind the trades that turned what the Fed might have hoped would be a leisurely and orderly winding back of the speculative imbalances in the system into a bloody rout as investors scrambled to be at the head of the exit queues.
It hasn’t helped that the Fed’s first really specific statements about how it might exit QE III coincided with some poor economic news out of China and signs of a developing credit crisis within that economy, which has been the main growth engine for the global economy since the financial crisis, nor that Japan’s version of quantitative easing appears to be faltering after some early signs of success.
The lack of transparency in the non-bank sector of the global financial system means it is impossible to understand with any precision the scale and nature of the trades that are being unwound but the extent of the volatility in markets since they concluded the Fed was starting to plan an exit of its own from QE III does suggest they are considerable and pervasive across asset classes and geographies.
There could be collateral damage or benefit.
The reversion of southern European sovereign debt yields to levels that better reflect the state of their economies and financial systems is an obvious vulnerability for the global economy and financial system and the scale of the capital outflows from emerging economies (or, for that matter countries like Australia) is moving currencies and markets so significantly that it could have real economic effects, both positive and negative.
No trade-exposed business in Australia is going to complain about a lower dollar but the wealth and confidence effects of tumbling equity and bond markets here and elsewhere could be significant.
As the great credit bubble created by the vast pool of liquidity created by the G7 central banks deflates as the carry trades are unwound (whether momentarily or for some longer period) there is likely to be considerable volatility until markets find new levels and new relativities.
At that point we’ll know whether Bernanke’s comments simply blew off some of the froth associated with overly aggressive risk-taking or kick-started a new and destructive self-reinforcing cycle in financial markets.