Markets hold their breath as Fed prepares to trim stimulus

Investors around the world have remained on tenterhooks ahead of the US Federal Reserve's much anticipated meeting, at which it is expected to declare the US economy now healthy enough to start scaling back its massive stimulus program.

With the meeting scheduled at early Thursday morning, Melbourne time, markets have largely been betting on a modest trimming of the Fed's $US85 billion-a-month ($90.9 billion-a-month) bond-buying program, which has seen trillions of dollars pumped into the US economy since last September.

A cut of $US5 billion to $US10 billion a month, with some analysts expecting a $US15 billion reduction, has already been priced in by investors, meaning that financial markets are unlikely to be rattled if a reduction of this size is announced by the Fed chairman, Ben Bernanke (pictured).

But a larger than expected winding back of the program - or tapering - could send global financial markets into the red and push the US dollar and long-term bond yields higher.

If the central bank is more cautious on the outlook for the US economy than expected and cuts the bond-buying program by a smaller amount, financial markets were expected to rally, at least in the short-term.

Under the program the purchase of long-term Treasuries and mortgage-backed securities was designed to have a two-fold effect: Not only would it pump money into the economy, it was also designed to spur on a recovery in the US housing market by keeping lending rates low. Mr Bernanke and other Fed officials have been at pains to point out the tapering would not be a tightening of monetary policy, and that a slowdown in stimulus does not mean a rise in short-term interest rates.

Analysts are expecting the Fed to finish tapering in the first half of next year, provided the unemployment rate falls below 7 per cent.

The open-ended third-round quantitative easing program involved buying $US40 billion in Treasury notes and $US45 billion in mortgage-backed securities every month. Since the start of quantitative easing in late 2008, the Fed's balance sheet has hit a record level of more than $US3.5 trillion.

The tapering is expected to focus on Treasuries, with mortgage-backed security purchases remaining largely untouched.

Analysts have warned that the size of quantitative easing means the impact of its wind-back - and its end - would be unclear.

Credit Suisse's equity strategist, Damien Boey, said the market's reaction to tapering expectations - such as a rise in bond yields as investors flee the asset class - have already started to stymie economic growth. He warned against too much optimism about tapering. "As bond yields have risen in America, the economy has slowed very sharply," Mr Boey said, citing a slowing of housing demand and refinancing activity.

While higher bond yields are often seen as a sign of growth, Mr Boey said the rise in yields could be a false signal and instead be indicating an increase in risk premiums.

Financial markets have been on a roller-coaster ride since Mr Bernanke signalled the start of a tapering process earlier in year, amid fears of withdrawal of the cheap financing that has seen investors pile into higher-yielding and risky growth assets, such as the Australian dollar and emerging market currencies and equities.

Emerging markets have been badly hit as funds flow back into Europe and the US. Hardest hit have been such countries as India and Indonesia, which have used foreign capital to fund their current account deficits.

Bond markets have also suffered some of their biggest monthly outflows in recent months.

At the same time, the US dollar has gone from strength to strength as investors return to it and dump riskier growth assets, such as the Australian dollar.

In June, the mention of a possible tapering by Mr Bernanke sent the Australian dollar plunging in a few seconds.

Investors would be looking for guidance from the Federal Open Market Committee on the size of the first stimulus wind-down and how the Fed would carry out its next reductions.

Some scenarios include a cycle of cuts that see bond purchases automatically reduce by an additional $US5 billion a month. Others are more data-dependent, with tapers according to the strength of future US economic figures.