US bond tapering - Time to wear our seat belts

Take a look at the 3 possible scenarios and the market's response to it

Will he taper or won’t he? This is the big question that financial markets world over are pondering on. Tapering is easing of the bond buying program which resulted in surge of liquidity in the global markets. Federal Reserve is presently, through its third round of quantitative easing (QE3) pushing in $85 billion every month. Reduction of this flow, if at all it happens, is what is keeping markets nervous. Expectations range from a postponement of tapering to a reduced tapering of $20 billion or more every month.

There are some who say that Federal Reserve’s objective of QE3 has not be completely fulfilled, hence it is unlikely that they would announce a tapering. Recent employment data and retail spending data suggests that the US economy is not yet out of the woods.
 

 

But markets have already factored in some amount of tapering. Since Ben Bernanke’s speech on May 22 where he said the central bank could take a step down in the pace of purchases in the ‘next few meetings’, Ten year treasury yields have jumped almost 1 percentage point. They are at levels last seen in August 2010, when the second round of easing was announced. Equity markets, especially emerging markets one have gone through multiple rounds of spasm. Debt and currency markets have left a trail of destruction in emerging markets since that speech.
 

Three scenarios are possible in Ben Bernanke’s speech. First, he might delay tapering or he might go in for a gentle taper or he would go in for a sharper surgical cut and wait for the dust to settle.
 

Let’s look at the possible market response in all the three cases.
 

1) Tapering delayed
 

Markets might move up marginally as Ben Bernanke would not like to delay it only for a few months. US balance sheet has already bloated to a record $3.66 trillion as compared to $1 trillion before quantitative easing were announced. Delay would also signal that the central bank is not yet comfortable with the economic progress. However the presumption that QE’s have been good for the market might keep the sentiment bullish.
 

2) A gentle taper
 

This is the most probable outcome. Bets are stacked up on a $5-15 billion easing per month. This way, the Federal Reserve will not be rocking the markets too much and at the same time easing interest rates. Equity market would thus remain flat with an upward bias as a gentle taper would suggest economy is not doing too badly.
 

3) A sharper taper
 

A bigger cut in bond purchases of $20 billion or more would pull down world markets and send bond yields through the roof. Higher borrowing cost would hurt the US economy severely and cripple the housing sector which has posted a handsome recovery over the last few months. This is the least probable outcome of the meeting.

Along with the taper announcement, forward guidance will be of importance for the markets. Ben Bernanke will have to cool nerves by giving his stressing that interest rates will remain low as long as unemployment is back in the safety zone of less than 6.5%. Base interest rates in the US are 0.25%
 

The importance of Ben Bernanke’s speech to India can be judged from the fact that RBI Governor decided to postpone his policy measures to accommodate US Federal Reserve’s actions. Indian markets (equity, currency and bond) were one of the worst affected after Bernanke’s May speech when he hinted at tapering. Now that tapering is likely to be a reality, it’s time to wear our seat belts.