Markets are betting QE cannot last much longer

November 15, 2013 11:29 am

Markets are betting QE cannot last much longer

John Authers

Cracking the code of the new Federal Reserve chief will be key

Ultimately, the Federal Reserve will remove its extreme policies of monetary stimulus, because ultimately the US economy will stage a recovery. And ultimately, the remarkable onward march of the US stock market will be thwarted and go into reverse. The problem is to work out what “ultimately” means, and exactly when these things will happen.This is the issue of the week, as market watchers get back to parsing the Fed’s words. When the leadership of a central bank changes hands, it takes a while for the new head to work out an idiom with which to address the market.

Jean-Claude Trichet, formerly of the European Central Bank, developed code words, such as “vigilance” to signal what he had planned for the next meeting. Alan Greenspan, of the Fed, opted to speak in Delphic riddles. And Ben Bernanke, soon to leave the Fed, with revolutionary forms of forward guidance, appears to have attempted to tell it like it is – although the shock in September when he opted not to start tapering off so-called “QE” bond purchases, shows that there has still been ample scope for misunderstanding.

Janet Yellen, nominated to take over as Fed chair next year, was introduced to much of the American public for the first time this week, as she gave testimony to the senators who will vote on whether to approve her nomination. It also provided the first play on what will probably be a long-running game that she plays with the market.

The critical line in her testimony, released on Wednesday, was that a “strong” recovery would “ultimately enable the Fed to reduce its monetary accommodation and reliance on unconventional policy tools such as asset purchases”.

What did she mean by this?

At one level this is either meaningless or obvious. Given a strong recovery (and many believe this will not happen), then that would obviously let the Fed stop taking measures that have always been presented as exceptional policies designed to fight a crisis.

But why the choice of the word “ultimately”? Many agreed, I think correctly, that this was a deliberate indicator that Ms Yellen sees no urgency about tapering off the bond purchases with which the Fed is trying to spark the economy back into life. The chance that the Fed will choose to start the tapering process as early as next month’s meeting of its Monetary Policy Committee now appear to be close to zero.

Ms Yellen had ample chance to correct any misunderstandings under questioning from senators, and chose not to do so. So, more sugar from the Fed for longer. And therefore, more gains for US equities. The S&P 500 made a record close after the transcript of Ms Yellen’s testimony was released on Wednesday, and another high after her answers to senators’ questions on Thursday again failed to include any hawkish warnings.

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Fed chairs’ interactions with markets are governed by game theory. They try to build their credibility for the next round. Thus it made eminent sense for Ms Yellen, a reputed monetary “dove”, to create room for manoeuvre by talking hawkishly. It also made political sense, as many Republican senators are hawkish. That she did not drop any hawkish hints, therefore, looks like a sign of dovish intent.

In this context, it is not surprising that stocks did well, but rather that bonds did not do much better. Yields, which move in the opposite direction to prices, briefly reached 3 per cent when the market thought tapering would start in September. But although that date has been pushed forward indefinitely, they remain at 2.7 per cent – a full percentage point higher than they were when “taper talk” started in May. Why did bonds not strengthen more? And why did the dollar, which should have been weakened by the Yellen testimony, hold up well?

Steven Englander, Citibank’s foreign exchange strategist, has an answer. Bond traders know that QE is having a distortive effect. The Fed is set to buy the majority of the bonds that the US Treasury issues next year. Indeed the Treasury appears to be altering its issuance policy to issue bonds with the maturities that the Fed wants to buy. Ms Yellen knows this. The market is quietly betting that QE cannot last much longer.

That implies, if more stimulus is needed, that it will have to come from some different policy. The most likely candidate is more aggressive forward guidance. Ms Yellen might promise to keep rates at zero for a particular time, or cut the unemployment rate – currently 7 per cent – at which the Fed would be permitted to raise rates.

Introducing such a policy would offer plenty of chances for Ms Yellen and markets to misunderstand each other. There is every chance of market turbulence next year once she has taken over.

But until the end of the year, the stock market seems safe. In the short run, it would be unwise to fight the Fed, even though the policy of bond buying must at some point be removed. Ultimately.