THE DISTILLERY: Taper talk

The question of when the Federal Reserve will in fact start winding back QE3 and the consequences of that action continue to dominate the offerings of the Australian business commentariat. There’s a pretty good reason why. Since the global financial crisis the world’s largest economy has been beholden to unconventional monetary policy that’s finally being unwound by Fed boss Ben Bernanke.

For years we’ve wondered how strong the US economy is on its own two feet. At long last, we’re about to find out.

Fairfax’s Malcolm Maiden reports that many market onlookers have been wondering whether to trust the utterances from Bernanke, or the doubt from PIMCO founder Bill Gross who believes the US economy will not behave at the Fed expects.

“A retreat could begin later this year and end by mid next year if the economy motored along as the Fed expected, he said. It could be withdrawn more slowly if the economy fell behind the Fed’s forecasts, and could even expand beyond $US85 billion if the economy tanked. The concern highlighted by Gross’ comments is that, if the flexibility Bernanke says the Fed has is based on a chronically over-optimistic read on the US economy, growth will dematerialise as debt yields and borrowing costs rise, and the Fed will still not react. We don’t know whether he is right or the Fed is right. What we do know is that we won’t die wondering. Data on the US economy is voluminous and dependable enough to decide the matter in fairly short order. Gross says in particular that Bernanke is underestimating the impact of tighter monetary policy on the housing market, which sparked the financial crisis and is the engine of America’s recovery.”

The Australian Financial Review’s Chanticleer columnist Tony Boyd says one market participant who has been around for a while believes the withdrawal of QE3 will be akin to breaking the sound barrier. There will be a sonic boom, then calm conditions will return.

“The Fed’s withdrawal from the US bond markets means that interest rates will be set by market forces. The so-called risk free rate of return, which is the interest rate on government bonds, will no longer be set by artificial means. The world’s biggest economy will have to stand on its own two feet for the first time since the global financial crisis hit in 2008. This has ramifications for any interest rate-sensitive stocks. Also, it is not clear when market will return to ‘calm conditions’. Some would argue that because all asset classes are valued relative to the risk free rate, which has jumped from 1.6 per cent to 2.5 per cent in the US in the space of six weeks, every investment will be impacted by the US central bank pulling back from its years of market support. Inevitably, the developments in the US have flowed through to Australia. The equity markets were shaken but the most telling impact has been in the currency market.”

Business Spectator’s Stephen Bartholomeusz explains how investors have assumed for some time that the sluggish economic conditions in Europe and the US, both brought about for varying reasons, would mean unconventional monetary policy would remain in place for some time.

“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.”

The Australian Financial Review’s economics editor Alan Mitchell explains some of the fear behind the Fed’s signal of a withdrawal from a different angle.

“The markets are jumpy because of the risk of a repeat of the 1994 bond market meltdown, when an unexpected tightening of US monetary policy caused long-term bond rates to jump 2 percentage points in a year. The risk of a repeat of 1994 will be lowered by the efforts of the Fed and other major central banks to make sure markets are not caught by surprise. The statement by the Federal Reserve’s chairman, Ben Bernanke, that the Fed probably would start to “taper” its bond purchases later this year with a view to phasing them out by the middle of 2014, is another step in the process of reducing the risk of surprise. However, while the risk of a 1994 event can be minimised, high leverage and fragile banks mean that any repeat of such an event would be much more damaging.”

And while some investors are confident that the US economic recovery will help shelter Australia from the slowdown in China, as it has in the past, The Australian’s economics editor David Uren explains why this mightn’t occur to the degree they would like.

“In the Asian financial crisis in the late 1990s, the devaluation of the Australian dollar and an improvement in exports to advanced nations offset the collapse of exports to regional trading partners. Asia’s share of Australia’s exports fell from 56 to 46 per cent, while exports to OECD nations, excluding Japan, rose from 35 per cent to 44 per cent. However, the passage of 15 years means that Asia now takes 74 per cent of Australia’s exports while the OECD excluding Japan is only 21 per cent, so there is less scope for US strength to make good any weakness from China."

The Australian’s John Durie explains how the banks protect their profits amid interest rate changes with the help of a new index.

The Australian’s Barry Fitzgerald previews the pending due date for the world gold industry to come up with an agreed method to report the all-in cost of producing an ounce of gold, rather than the cash-cost. The result will be that we discover just how hard it is to make a dime out of gold.

Fairfax’s economics correspondent Peter Martin says he doesn’t quite get the productivity debate and is thankful that the Productivity Commission doesn’t get it either.

Alright, that’s not quite the case. What Martin is getting at is that productivity is actually quite an annoying thing to measure and the commission has recently released the first of what will be a regular set of updates illustrating just that.

And finally, Fairfax’s Adele Ferguson and Chris Vedelago deliver another piece on the Commonwealth Bank financial planning scandal.