Markets find the virtue in taper's modesty

Markets reacted positively to today's tapering announcement, with the Fed continuing to pump cheap liquidity into the system in 2014. But concerns remain over the elevation of asset prices and mispricing of risk.

It might appear curious that the reality of the taper has been greeted with equanimity, given global markets were thrown into turmoil in May at the merest hint that the Federal Reserve might taper its massive bond and mortgage-buying program.

There are, however, a number of possible strands to the explanation for why markets responded differently to the announcement.

An obvious one is that, post-May, the markets have anticipated it. With each set of Federal Reserve board minutes and each public appearance by Ben Bernanke strengthening expectations that the start of the taper would indeed be announced this year, it could be said that the Fed did an excellent job of conditioning the markets for the announcement the Fed made overnight.

Another is that the amount of the taper is so modest as to have no meaningful impact. Cutting $US10 billion a month off the rate of bond and mortgage buying is, according to previous analysis by the Fed, equivalent to perhaps a basis point or two at most increase in US official rates.

The Fed’s balance sheet has been expanded by the three quantitative easing programs over the past five years to a smidge under $US4 trillion. It is still going to be pumping $US75 billion a month – an annualised $US900 million – more into the US economy.

While that rate may be stepped down through 2014, the Fed is still aggressively maintaining what has been the biggest monetary policy experiment in history.

While the jury is still out on how truly effective the program has been, and what its ultimate consequences might be, the US economy is at least steadily improving, albeit incrementally, and there have been no signs of the policy kindling inflation.

The other ‘leg’ of the Fed’s policy has been to hold short-term interest rates close to zero. With the Open Market Committee saying that it would maintain that position “well past the time that the unemployment rate declines below 6.5 per cent”, there was nothing to unsettle markets on that front. The US unemployment rate is now 7 per cent.

With the Fed still planning to begin 2014 by pouring more cheap liquidity into the system, it is little wonder that the markets didn’t take fright.

The markets don’t have many options. One of the key criticisms (and great fears) of the Fed’s policies is that while it has had virtually no impact in encouraging business investment in the US, it has exported cheap money into far corners of the globe in search of positive returns.

Investors’ consciousness of risk has been dulled, risk has been mispriced and risk asset prices have been pushed up to levels difficult to support on any conventional assessment, thanks to the artificially low cost of funding.  In one sense, investors have been encouraged (or forced) into what hedge funds would regard as carry trades or yield arbitrages.

The Australian dollar and Australian banks stocks – and the record low official interest rates -are visible examples of the distortionary effects of the US policy. But after the wake-up call in May, funds poured out of emerging markets as some of that hot money fled back to safety.

The gap between investment grade and junk bonds in the US has narrowed to levels that make them almost indistinguishable, in yet another example of the distorted pricing the Fed has created.

The Fed isn’t alone. Japan has its own version of quantitative easing, while Europe’s rate settings are also effectively at zero. The flow-on effects of the monetary policy settings in the key global economies can also be seen in currency relativities.

Because the global flows of funds are quite opaque, there has been no certainty as to what might happen when the tapering truly gets under way.

There are almost certainly a range of asset price ’bubbles’ in markets and economies around the globe that have been inflated by the scale of the money-printing occurring and the subsequently modest cost of funding.

At some point, those bubbles have to deflate. The great fear about the taper – reflected in the sell-offs in May – was that the announcement might provide the trigger.

The Fed’s cautious first move, however, didn’t provide the catalyst for a global markets meltdown that some feared. The path it has outlined for the future of both the tapering and US official rates is so gradual and hedged by caveats that it might be possible to manage a gentle deflation in asset prices, or a lengthy pause while the markets wait for real economic activity to validate prices. There still aren’t many (if any) lower-risk sources of real returns available anywhere.

The market’s easy digestion of the Fed announcement appears to have sparked some optimism that a gradual but seamless shift towards more normal monetary policy settings is now probable.

But the elevated levels of asset prices and the latent risks within them (not to mention the fragile states of key economies) suggest it it is too early to reach that conclusion – and that’s likely to remain the case for some time.

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