Markets take tapering in their stride, for now

The bond market had largely priced today's taper announcement, but the Federal Reserve could still surprise in the months ahead.

Yields on the 10-year US Treasury note show the bond market had already priced in the Federal Reserve’s decision to begin winding down asset purchases before the announcement.

The bond market has steadily pushed the yield on the 10-year US Treasury higher since May on the assumption a modest wind-back of the current monetary policy was only just around the corner. Basically, before today the bond market, which is arguably the most sensitive financial market to monetary policy, expected the taper and was sitting around waiting for it to eventuate.

Markets have been in limbo since the Federal Reserve decided not to alter its monetary policy in September, so the decision to actually begin tapering has been overwhelmingly well-received by the US equity market. It confirms the bond market has been on the money and the equity market has welcomed the decision, erasing the fears caused by uncertain monetary policy.

Yields on the 10-year US Treasury have only gained 0.04 per cent since the decision was announced and currency market movements have been modest, confirming these financial markets had priced in much of the $US10 billion reduction in asset purchases.

Currencies across emerging markets were sold off heavily in what was a rapid fire event, leading into September’s Federal Open Markets Committee meeting on tapering expectations alone. Since this time, these currencies have strengthened somewhat against the US dollar and have found a relatively stable trading band. Bond and currency markets have essentially been ahead of the tapering decision.

Emerging market currencies are only around half a per cent or so lower against the US dollar on the back of tapering. There is no race for the exit taking place.

Financial markets had expected the initial reduction to bond buying to be around $US10 billion per month – this isn’t a number that has shocked markets. However, room for surprises will come in the months ahead as future FOMC meetings will determine how fast the Federal Reserve will turn off the liquidity tap to markets.

Any FOMC decisions that catch markets by surprise will no doubt distress financial markets and create significant volatility. Given the response to Ben Bernanke’s Freudian slip in May, there is little doubt incoming chair Janet Yellen will pick her words carefully when providing forward guidance concerning monetary policy.

Speaking of Yellen, she may not be as dovish as the market had anticipated after voting in favour of the decision to reduce asset purchases.

Markets are in the early stages of getting through the first tapering announcement, but future announcements could bring wildly different responses.

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