The Federal Reserve Bank has been playing a particularly important role in driving market sentiment recently. First there was Larry Summers, former US Treasury Secretary, dropping out of the race to replace Ben Bernanke as the central bank’s head when the position falls vacant next year.
Then we had the surprise news that monetary easing is to continue at the previous pace, with tapering not yet taking place. It all added to a boost for risk markets.
With emerging markets bouncing back, Treasury yields tumbling and US indices hitting new highs, it felt like a knee-jerk reaction. After all, surely this means that tapering is merely deferred, not abandoned? And it suggests that the strength of the US economic recovery is less robust than previously thought.
However, perhaps it also indicates that Bernanke’s quest to stimulate inflation, which remains below the Fed’s target, as a debt reducing mechanism is still on the agenda.
If so, then bonds continue to look vulnerable. US Treasuries saw yields move from below 2 per cent before the announcement last May that tapering back the amount of bond purchases was under consideration, to over 3 per cent in anticipation of action by the Fed.
Yields fell to under 2.7 per cent in the wake of last week’s announcement. While inflation is below these yields – and would still be lower even if the target is reached – once we learn that the amount of bond purchases to be carried out will reduce, we can see them chasing back up again.
Not that the introduction of tapering is likely to be that significant. Presently the Fed is buying some $85bn of bonds and mortgage-backed securities each month. All that tapering means is that this figure will reduce, perhaps to $70bn a month initially although it would be a signal that quantitative easing, as this exercise is known, is reaching the end of its useful life.
Quantitative easing has been a huge financial experiment that probably only history will be able to judge as successful or otherwise. Vast tracts of the developed world have adopted it is a means of staving off recession in the wake of the financial crisis.
It was expected to push the rate of inflation higher. Instead, it has been the consumer that has borne the brunt of the slow unwinding of the over-indebtedness that stimulated the global downturn, with wages held down and living standards squeezed.
Remarkably, these hard pressed members of our society have continued to spend, albeit in a more careful fashion, which suggests that savings are being raided to fund the maintenance of lifestyles. This is not what governments and central banks have wanted although they have been happy enough to accommodate these patterns if it means recession is avoided.
Keeping interest rates down was meant to encourage investment from the corporate sector. Thus far businesses have proved cautious and have preferred to hoard cash.
But economic confidence is slowly returning. What the Fed is clearly anxious to avoid is undermining the fragile recovery that is taking place. This policy has led to a rise in house prices in the US, while a similar trend has been established here also. This adds to a sense of wellbeing that belies the harsh realities of declining living standards and a debt overhang that remains daunting.
While I welcome such moves as add to the upward pressure on financial markets, the degree of sensitivity that has been demonstrated makes me concerned that when the Fed finally does implement tapering, markets will experience significant volatility. Still, a few investment houses are predicting a move above 7,000 for the FTSE 100 Index some time next year. If they are right, it won’t be before time.
Brian Tora is an associate at investment managers JM Finn & Co