Quantitative squeezing: Markets chase risk relief

For the past month global markets have been gyrating as they have priced in an expectation that the beginning of the end of the US Federal Reserve’s $US85 billion-a-month bond and mortgage buying program was drawing closer. Overnight the expectation was essentially confirmed, which triggered another bout of market turmoil.

The sell-off in equity, bond and currency markets doesn’t appear to be what Fed Reserve chairman Ben Bernanke intended when he outlined the Fed’s preferred pathway towards monetary policy normality after the Federal Open Market Committee’s two-day meeting ended.

In fact what he outlined, and the FOMC’s statement detailed, was what the market had anticipated.

If the US economy remains on track, unemployment continues to edge down and inflation remains within the Fed’s comfort zone, the QE III program of bond and mortgage buying will begin to taper off later this year and, all being well, end around the middle of next year. Some considerable time later the Fed expects to start considering lifting official US interest rates from their current level of close to zero towards more normal levels.

Despite the fact that Bernanke’s comments were very much in tune with the markets’ thinking over the past month there was still a mass exodus from risk assets.

That might suggest that the QE III program has, in one aspect at least, been too successful.

The combination of a federal funds rate around zero and the large-scale purchases of bonds and mortgages was designed to encourage/compel investors to shift up the risk curve, and they did.

Equity markets have generally been very strong this year and there have been massive flows of funds into emerging markets and elsewhere in search of yield and returns.

Until recently, the Australian dollar had been propped up by those flows, despite the ending of the resources boom and the weakening performance of the wider economy.

Over the past month markets have been exceptionally volatile, gyrating in both directions as investors tried to second-guess the Fed’s intentions.

The big sell-off last night, which saw the Australian dollar tumble below US 93 cents, would appear to be an admission by investors that they had acquired too much risk in the belief that the Fed would maintain the QE III program at its current levels for quite some time yet.

That’s always been a possibility, indeed members of the FOMC have increasingly expressed concern that maintaining the program would lead to excessive risk-taking and financial imbalances that could create new and different problems in future.

In reality, while Bernanke did more clearly define the Fed’s preferred pathway towards the exit from QE III, he really said that US monetary policy would remain expansive for quite some time yet.

The Fed may start ‘’tapering’’ its bond and mortgage-buying program later this year but it will still be buying bonds and mortgages into the middle of next year and there is no expectation that it will be selling any of the trillions of dollars of securities on its balance sheet within the foreseeable future, indeed it appears the Fed’s current intention with the mortgages it holds is that it will hold them to maturity.

Similarly, the Fed doesn’t expect any movement in the federal funds rate from its current level of close to zero until 2015 or 2016 and that will be dependent on the condition of the US economy, the unemployment rate and inflation and even when it does start moving Bernanke made it clear the plan was that any increase would be very gradual. He talked about easing off the stimulatory accelerator rather than stepping on the brakes.

The markets’ response to his comments, which included a positive assessment of the state of the US economic recovery, was effectively to capitalise the beginning of the end of the QE III program into asset prices – markets are forward looking and are now pricing in the end of the near riskless put option they have had against the Fed.

What isn’t clear, although it might become clear over the next few months, is how much risk the markets had absorbed over the course of the QE programs and therefore how much has to be unwound.

The volatility over the past few weeks and the response to Bernanke’s statements last night would tend to suggest there are a lot of suddenly nervous investors out there trying to quit or cover their exposures. It could be quite a risky and rocky period ahead.