On balance, the minutes from July’s US Federal Reserve meeting provided yet more ammunition to those expecting an imminent tapering of bond purchases.
A number of participants felt that market expectations for both asset purchases and policy rates were “well aligned with their own expectations’’. In relation to this, several stated that the recent tightening of monetary conditions was a healthy development that was necessary to quash excessive speculation.
The will they, won’t they debate has dominated financial headlines since late May, when Bernanke first broached the idea of tapering. His comments have led to a market that has become obsessed by the timing of the Fed dialing down quantitative easing.
Markets have poured over every piece of economic data, endlessly speculating over when the punchbowl will finally be removed. It has led to the counterintuitive situation where bad news is interpreted as good news and poor economic data is often positive for risk assets.
In all likelihood, tapering will begin in September. US economic data remains solid, if unspectacular, and – barring a dire August non-farm payrolls number – a modest scaling back of monthly purchases to between $60 and $75bn seems the most logical move from the Fed. So what does this mean for markets?
We may be in the minority but believe tapering in September will actually prove positive for risk assets and core government bonds. Why? Simply put, the pain has already been felt. Investor positioning within core bonds, and within related asset classes, has become extreme and overly pessimistic.
It has been anything but a pleasant summer in bond world. The back-up in yields and resultant fall in capital values has been brutal, especially for those fishing at the long end of the curve. In the past four months 30-year Treasuries have lost more than 15 per cent and mortgage rates in the US now stand 125 bps higher than their lows.
Despite constant rhetoric of maintaining price stability, we should not forget that the overriding objective of western governments, and by extension western central banks, is financial repression. Interest rates will be anchored at rock bottom for the foreseeable future to erode away our debt mountains, while higher levels of inflation will happily be tolerated.
Market expectations have brought forward the first interest rate hikes in the US to the beginning of 2015. This is way too early. We see a shift upwards in bond yields further out on the curve as being overdone.
While we remain cautious and underweight the asset class, we have been mildly increasing exposure of late. The Fed has no interest in seeing bond yields move materially higher. Such a move would choke off a recovery in the housing market and add billions of dollars to the annual interest on national debt.
Perversely, a September announcement of a mild tapering could be the catalyst that sees both government bonds and risk assets move higher. Any announcement would be likely to accompany more specific forward guidance and possibly a drop in the unemployment threshold to 6 per cent from the current 6.5 per cent.
Thinking further afield, a subsequent rally in equity markets could be led by the defensive bond-like proxies which have been crucified of late. Emerging markets, which have endured a torrid summer, may also be beneficiaries as their currencies regain some ground on the back of falling US rates and a weakening dollar.
Such an outcome is by no means a guarantee but with the market so universally bearish on government bonds and emerging markets, now feels like the time to be adding cautiously to both.
Tony Lanning is portfolio manager at JP Morgan Asset Management Fusion Funds