Macro Focus: Who is afraid of tapering?

by: Han de Jong

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Conclusions:

  • QE has had (at best) only a modest persistent, noticeable impact on US bond yields contrary to conventional wisdom. The biggest effect was the announcement effect. The same may be true for tapering and the end of QE.
  • US mortgage applications dropped sharply during the tapering dry run as mortgage rates rose. Assuming that bond yields will not rise sharply again when tapering starts and QE ends, the US housing market should be able to cope.
  • QE has supported general confidence. As the economic outlook is increasingly positive, the need for such support of confidence is lessening. Having said that, given the widespread unease surrounding tapering and the end of QE, volatility could easily rise temporarily when the tapering starts, but tapering is unlikely to significantly damage general confidence.
  • Equities have performed well in recent years as earnings growth and the earnings outlook improved. QE probably has provided some additional stimulus, but has not been the main driver. QE has not pushed equity valuation to unrealistic levels. Equities could show short-term vulnerability to the end of QE in the short term, but the recovery will eventually dominate.
  • Commodities seem to have received some support from QE1 and QE2, but little from QE3. The tapering dry run also had little impact. I see no reason for a change in that pattern.
  • Some currencies of emerging economies were badly hit by the tapering dry run. They are the currencies of countries with relatively large external deficits, making them vulnerable to any meaningful change in capital flows. I expect them to remain vulnerable when tapering starts and QE ends.
  • Emerging equities were also hit by the tapering dry run, but regained confidence of investors who probably realised that these markets are supported by much better fundamentals than in the past. While I have confidence in these fundamentals, emerging equities could prove more vulnerable to the end of QE than many other markets.

 

Monetary policy has been extremely loose in many countries for a long time. And with good reason. The bursting of the credit bubble and the subsequent euro crisis have damaged balance sheets in the private and the public sectors in many countries. The very loose monetary policies are an effort to enable the economy to go through a deleveraging process with as little negative impact on economic activity as possible. The policies pursued by key central banks such as the US Federal Reserve, the ECB, the Bank of Japan and the Bank of England are unprecedented. History will tell how successful these policies have been and at what costs.

For now, one has to say, so far, so good. A depression has been prevented, the process of deleveraging is progressing relatively well and the global economy is on track for trend growth in 2014 and 2015. The next challenge is the gradual normalisation of monetary policy. The first step in that process is for the Fed to reduce the monthly asset purchases it is currently undertaking, usually referred to as tapering. Just over a year ago, the Fed started its third quantitative easing programme, QE3. This programme differed from the previous two in the sense that it did not have a fixed total amount or a preset end date. Instead, it was an open-ended commitment, initially to buy USD 40 bn worth of agency asset-backed securities and. Soon after, a commitment to buy USD 45 bn worth of US Treasury securities per month was added.

When Fed Chairman Bernanke last May said that the Fed would start tapering these purchases in the not too distant future, markets reacted very strongly. US government bond yields and mortgage rates rose sharply pushing mortgage applications down sharply, threatening to undermine the recovery. Market participants then expected the Fed to push ahead with its tapering plans in September, but it did not. We therefore call the period from May to September the ‘tapering dry run’.

At some stage, the Fed will have to taper and end QE. The question now arises what will happen when they do? This is uncharted territory, so one cannot be sure. Conventional wisdom is that many asset markets have been supported by the QE programmes and that these markets will weaken when that support disappears. This note looks at various markets during the three QE programmes and during the tapering dry run. We conclude that fears for large and disruptive developments on financial markets are most likely overdone. It must be said, however, that we are merely looking at pictures here, not analysing underlying developments and forces. So the approach is simple, but at least we are looking at the facts here.

Government bonds

There is a widespread perception that QE programmes pushed bond yields down and that, as a consequence, tapering and the end to QE will lead to higher bond yields. Chart 1 casts serious doubt over how strong and persistent this influence has been. It is true that US bond yields fell sharply just before and during the early days of QE1 at the end of 2008. But during the remainder of the programme, yields rose and ended close to the levels just before the asset purchases started. When the programme had stopped, bond yields fell, which is counter intuitive. The experience during QE2 and QE3 is not fundamentally different. Of course, this is not an exact science where experiments can be performed in a controlled laboratory. All sorts of factors will have had an impact on bond markets during this period. And we do not know what would have happened if the QE programmes had not been carried out. One could also argue that ten-year Treasury bond yields were around 4% before QE started and were only some 1.5% when the tapering dry run started. It is just that the timing of the movement in yields does not lead to a compelling argument that QE has been the key driver. What should we conclude? First, that the downward effect of bond purchases on yields occurred largely as an announcement effect. And this announcement effect really only happened once, at the beginning of QE1. The question is, of course, why sustained purchases of bonds do not have a more persistent, noticeable effect on prices and yields. This is most likely related to the fact that pricing on all financial markets is interrelated. The Fed pushing bond up prices by buying them will trigger existing holders to sell their bonds and buy other assets. It simply is questionable whether a central bank can push a large asset market such as the one for US government bonds persistently away from where market participants think real value is.

Looking at chart 1 one wonders what all the fuss is about over tapering anyway. QE1 and QE2 finished abruptly with no damaging effects on bond yields. So why would QE3 be different? A possible answer is that QE1 and QE2 were closed-end programmes, limited to pre-announced total amounts, while QE3 is an open-ended programme. But still….

If the effect of QE on bond yields has been limited and largely restricted to an announcement effect, then the same may be true of tapering. And perhaps we have already seen the announcement effect over the May-September period. Chart 2 highlights what happened to bond yields during the tapering dry run. Yields clearly shot up. Market action during the May-September period looks a little like the reverse of what happened early on during QE1, although the drop in yields at that time was even considerably quicker.

The mortgage market

US mortgage rates are closely linked to bond yields. Chart 3 shows that the sharp rise in mortgage rates in the May-September period pushed mortgage applications down sharply. The conclusion is that the tapering dry run threatened to undermine the housing market. However, if we take the position that actual tapering and the end to QE will have limited effects on the bond market, then the logical conclusion is also that the housing market should cope well. Housing market indicators such as prices, starts, sales and the confidence of homebuilders, expressed in the NAHB index suggest that the market weakened during the tapering dry run, but has regained momentum since bond yields stabilised.

Volatility

If QE did not achieve persistently lower bond yields, then what did it achieve? Academics will long debate this question. An obvious area to look for an effect is confidence. The problem is that that is hard to measure. Using the VIX index of implied volatility on the equity market as a proxy for confidence sheds some interesting light on this issue. Chart 4 suggests that there is some evidence that QE has been positive for confidence, though this evidence is by no means straightforward. Volatility eased during QE periods, but then, it also eased sometimes outside of QE periods. What is clear, however, is that volatility did not rise materially during any of the QE periods. That only happened when the Fed wasn’t buying assets. This perhaps supports the tentative view that QE did support market confidence. What will happen next? The tapering dry run did not push volatility up to any significant degree suggesting that the economy and confidence in financial markets is strong enough to live without QE.

Equities

Chart 5 shows what happened to the US equity market during periods of QE. The evidence does not lead to an overwhelmingly clear conclusion. Equities generally did well during the QE programmes, but not all the time. In addition, equities also performed well outside the periods of QE. We do not consider valuation to be at an extreme and it is therefore difficult to substantiate the assertion that QE would have pushed the equity market to a level it could not have gone to without QE. It is noticeable, though, that the US equity market sold off after QE1 had ended (some 15%) and, again, after QE2 had ended (again some 15%) In both cases, the market relatively quickly regained the ground lost. Chart 6 highlights the taper dry run. The equity market became more volatile. There were three periods in which the market sold off, but the size remained limited to some 5% each time and the market quickly found its footing again. On balance, the equity market seems to have shrugged off the taper anxiety and has continued its upward trend.

I think it is fair to say that equities seem vulnerable immediately after QE ends, but recovers relatively quickly. Underlying fundamentals are the real drivers. If we are right thinking that global and US economic growth will accelerate in 2014, then profit growth should accelerate as well due to the operational leverage built into corporates after years of cost cutting. The implication is that equities should not be particularly bothered by tapering and the end of QE, though short-term volatility is likely.

Commodities

Chart 7 suggests that QE1 ended a sharp drop of commodity prices and had some modest upward effect, in line with conventional wisdom, though the evidence is not exactly overwhelming. During QE3 commodity prices have gradually slid lower. Tapering does not seem to have changed the pattern fundamentally. My conclusion is that tapering and the end of QE are unlikely to be decisive drivers of commodity prices in the period ahead.

Emerging FX and emerging equities

Emerging markets appear to have been affected strongly by the tapering dry run. Chart 8 shows that QE1 appears to have had some positive impact on emerging FX. The effect of QE2 was smaller (if there was an effect at all) and QE3 had no impact. Chart 9 shows that the currencies of three countries with material external deficits proved vulnerable during the tapering dry run.

The Indian authorities appear to have regained some confidence in their currency, but the Indonesian rupiah and the Brazilian real continue to be weak. The reason for this is perhaps that history shows that these sort of currencies are vulnerable when US monetary policy is tightened as capital inflows are reduced or reversed.

Chart 10 and 11 show what happened to Asian and Latin American equity markets during QE and the tapering dry run. The conclusion is similar to what was said about exchange rates of emerging countries. Emerging equities performed very well during QE1, were lethargic during QE2 and slowed a modest upward trend during QE3 until the tapering dry run. These equity markets sold off heavily during the tapering dry run. And this was not after years of strong outperformance. Quite the opposite, actually, emerging equities had performed disappointingly for some time. While these markets were affected when the tapering dry run started, they calmed down from July on. There can be two explanations for this. First, it is possible that markets stabilised because it was only a dry run, not actual tapering. Despite the talk, the money from the Fed kept flowing. A second possible explanation for the return of confidence is that investors realised that most of these economies have much better fundamentals now than they did prior to crisis in the past.

I conclude tentatively that emerging equities and forex are the assets most at risk from tapering and the end of QE. Even these assets, however, have their own merits and may well be able to weather the storm, which may yet turn out to be only a breeze.