Markets seem blase about tapering. They all know that the US Federal Reserve is likely to announce a reduction of bond purchases on Wednesday, but they're confident that Ben Bernanke has learned the lesson from the ructions which accompanied early rumours of the first tightening in US monetary policy in five years. Certainly the Fed will proceed at a measured pace, with comforting words. But reality could be worse than expectations. Yes, the first move is likely to be no more than a small reduction in the $85 billion monthly asset purchase. But this is just the thin edge of the taper. The likelihood is that all asset purchases will end sometime in 2014. The disappearance of this constant high infusion of fresh liquidity is going to prove a huge adjustment for all markets, not just bonds.
Between January 2008 and March 2013 foreign holdings of Treasuries soared from $2.4 trillion to $5.7 trillion with emerging economies' purchases a big factor as they tried to prevent excess capital inflows from destabilising their economies. But in the second quarter, the prospect of tapering had them desperately selling reserves to prop up their currencies - and foreign holdings of US Treasuries dropped by $124 billion, reducing the supply of cheap funding to the US Further reductions are likely, bringing further increases in US yields.
Other developed economies are also going to be hurt by the Fed's moves. Pre-tapering has already increased the yield on Germany's 10-year bund from barely above one per cent at the beginning of May to not much below two per cent. More expensive borrowing may weigh more heavily on weak European economies than on the relatively strong US.
As tapering proceeds, the main reason for investors to accept below-inflation yields on US Treasuries - the excess of cash in their hands - will disappear. The rate could easily rise from 2.8 per cent to over four per cent by mid-2014. In turn, higher interest rates will be hard on leveraged companies and equity investors. The fast share price gains of the past year could reverse quickly, as markets find the easy money times are finally over.
