Wincing as Ben hovers over the bandaid

Ben Bernanke’s equivocal commentary on the future of the US Federal Reserve Board’s quantitative easing program unsettled equity and currency markets. What would have happened had he declared the Fed ready to exit QE3?

While it is impossible to predict with any precision, the immediate reaction of the US dollar (which strengthened) and US equity markets (which weakened) and the way those responses flowed through into international markets suggests that a known timetable for the tapering of the Fed’s $US85 billion a month bond and mortgage buying program and a subsequent exit from it would have significant repercussions within markets, particularly sharemarkets.

It would, of course, be helpful to the economies, like Australia’s, which are being choked by the currency wars being waged as the bigger economies use devaluations as a mechanism for improving their competitiveness.

How big an impact an imminent end to QE3 might have depends on the extent to which one thinks risk assets have been inflated by the unconventional monetary policies being pursued by the Fed and its counterparts in Europe and Japan.

There are those who believe the Fed’s strategy, as well as those of other central banks, have already created asset bubbles in stocks and bonds, with the US stock market touching record levels and other markets also roaring along. Junk bond yields are at record lows. You could argue that the Australian dollar was in bubble territory when it was solidly above parity even after it was clear the commodity boom had ended – but it is now deflating.

Certainly, starved for yield, investors have pushed into riskier asset classes and been prepared to accept greatly diminished risk premia for their exposures.

Bernanke himself said the Fed was aware of the risk that keeping monetary policy to loose for too long could fuel asset prices bubbles, although he also said the Fed believed major asset prices were justified by the economy’s fundamentals. The second leg of that comment was a bit of a stretch, given that while the US economy is showing signs of recovery they are relatively weak and fragile.

It is possible to rationalise the behaviour of markets.

Ultimately the value of a share is a relatively simple piece of arithmetic, albeit one based on sets of hypotheticals. It is the net present value of the company’s future cash flows and in a low-interest rate environment (should that be no-interest rate environment?) the discount rate used to help value those future cash flows is a lot lower than it used to be, pushing the net present value up.

The reality that the US economy has improved, that Europe has, for the moment at least, held together and that Abenomics is having some positive impacts in Japan supports some level of market optimism about the outlook. US corporate profits and balance sheets are also quite strong and the shale gas revolution provides the promise of stronger growth in the longer term.

Those factors help support a conclusion that there is a rationale for financial markets to be bullish, although they don’t help to determine whether that optimism has become dangerously excessive.

What would appear obvious, however, regardless of whether financial markets are in bubble territory or not, is that the markets are very sensitive to the QE3 program and any prospect of it being tapered or ended.

The reaction to the vague comments Bernanke made overnight – when asked whether the Fed would reduce the rate of bond purchases by September, he answered that he didn’t know – would, however, suggest that any confirmation of the beginning of the end of QE3 would produce quite a negative reaction, and probably quite a substantial one, in markets.

Whether that would constitute the bursting of a bubble or just a major correction to somewhat inflated financial asset prices isn’t of particular consequence.

The more meaningful conclusions are that stocks would fall, bond yields would rise (and therefore the value of bonds would fall), those currencies inflated by the artificially depressed US dollar would tumble as it strengthened and that anyone significantly leveraged to those markets could experience significant pressure.

If financial assets are in bubble territory, there would be the risk of another financial crisis. If they aren’t, it would just be painful for those with long positions in the more vulnerable asset classes.

The longer all these unconventional monetary policies remain in place, of course, the more likely it would be that somewhat overvalued markets would move into bubble territory and increase the risk of crisis.

At this point the Fed’s minutes appear to be suggesting that it could begin winding down its program towards the end of this year, although it has reserved the option of both scaling back the program of bond purchases but subsequently expanding it again, depending on the state of the US economy.

For those better-managed economies caught up inadvertently in the crossfire of the quantitative easing programs of the major economic regions, the end of those programs can’t come quickly enough.

Judging from the tone of Bernanke’s comments, however, the Fed has invested so much in the QE programs that, with near zero official rates, as its only major policy tool it is reluctant to risk winding it back prematurely or at too rapid a rate.

The uncertainty as to when and how the Fed will start to exit or scale back QE3 is going to continue to drive speculation and volatility in equity, currency and bond markets. Actual knowledge, however, could be even more disruptive and, if there are bubble dimensions to asset values, destructive.