The US Federal Reserve’s (US Fed’s) decision to taper their Quantitative Easing (QE or money printing) program has been well telegraphed going into this week’s US Fed meeting. However in many ways the real story has been how the market has adjusted to the second take on taper as opposed to the news itself.
If we cast our mind back to June the market response was totally chaotic, shock waves were sent through emerging markets, bond markets and share markets.
Going into April of this year the prevailing view of many was that QE was going to remain a constant for the foreseeable future as US economic data was poor and the market worried about the very real threat of disinflation. This saw market participants significantly increase their exposure to so called risk free assets such as government bonds. The reason was simple, the US Fed had pledged to buy $40 billion a month every month.
Lower short-term and long-term interest rates encouraged a chase for all kinds of assets, especially those that delivered yield. No doubt the increase in speculation on the back of a premise that rates were low forever troubled the US Fed.
Ultimately the decision was about risk versus return. While in a perfect world the US Fed would have loved to keep stimulating the US economy in order to reach a sustainable level of economic growth, however, the cost (or risk) of continuing the exercise in terms of this market speculation and drive for high yield assets perhaps started to mount quicker than what had been anticipated.
Equally while US Fed Chairman Ben Bernanke clearly feels the exercise has been of benefit, there is no question that it has under-shot in terms of the benefits to the real economy as is evidenced by declining distribution of wealth, lower participation rates and still sticky under-employment.
So by reducing QE, we are muzzling a programme which ultimately underperformed and delivered risks and side-effects that are difficult to quantify. Stated in that context the decision to reduce is almost sensible in some way as the decision to taper now removes what has been an explicit guarantee that rates will be supressed over the long-term forcing many investors to reconsider asset values and risk in a environment of higher interest rates… nothing last forever it seems.
Surprisingly the US Fed’s decision was taken particularly well the second time round and as a consequence what was a significant risk in many participants eyes has not materialised. That risk being that the withdrawal of QE has the potential to be disastrous.
This view cannot as yet be refuted, however equally there is no doubt that markets have taken the actual taper in their stride on the back of a six month adjustment period, something that augers well for risk assets in the short term.