Bad sequel

'Hike huff' could disrupt markets

Last year there was a taper tantrum. Get ready for the hike huff.

Consider how the market responded to a San Francisco Fed study. The September 8 document made the fairly obvious observation that investors were more dovish than policymakers. Relative to the views of voting members of the Federal Reserve, the markets expect US rates to stay lower for longer, and to rise more slowly. That non-news helped trigger a rise in bond yields, a retreat in stocks, and dollar gains.

The twitchiness is understandable. There were severe market disruptions last year after the Fed hinted it would soon be slowing down the pace of its bond purchases. Investors fled assets perceived as risky. If anything, more is now at stake, because the reversal then was temporary. Once things calmed down, the hunt for yield resumed. Even more money was ploughed into even less liquid assets.

For example, a Bank for International Settlements study says that, by May 2014, dedicated emerging market funds' assets had grown to $1.4 trillion, or 8.5 per cent of outstanding emerging market equities and bonds.

Such illiquid markets will be especially vulnerable to another bout of Fed-induced risk aversion. Other assets, such as southern European bonds, will also no doubt suffer. That's bad enough. The new world of trading could add to the pain, and diffuse it in odd directions.

Thanks to tighter capital rules, banks are less willing to put risky assets on their books, especially when prices are falling and holders are desperate to get out. Investors may find that they cannot de-risk in the obvious way, by reducing their riskiest position. In desperation, they may sell less risky but more liquid assets. This happened in mid-May when Italian bonds and bond futures suffered some of the steepest losses during a peripheral euro zone debt selloff triggered by a development in Greece. The taper tantrum was no fun. The hike huff could be worse.