Drawing a line in the sand but then failing to follow up with the threat when the line has been crossed is generally seen as an unwelcome weakness in most quarters, but not in financial markets if we are to judge based on investors’ reaction to Obama and Bernanke’s respective climb down in September.
Bernanke one day famously declared that it would be easy to exit QE in an orderly way. Maybe, he meant that it would be easy for him but not for the world to exit QE. Indeed, he is stepping down at the start of next year, after having printed more than $2 trillion in the space of 5 years, leaving to his successor the task to try to put an end to what he himself started in 2009.
Well, easy, it won’t certainly be. The Fed was apparently “puzzled” by the bond market’s reaction to the tapering announcement (US 10 year yield almost doubling between May and August), saw rather lukewarm data on the residential construction market, got afraid of the possible impact that rising long bond yield would have on mortgage rates, potentially nipping in the bud the just nascent housing recovery, and then decided to do nothing, at everybody’s surprise. There must be some pretty naïve fellows at the Fed.
As we discussed in the last monthly comment, what matters is not the precise timing for tapering nor accurate forecasting for the sizing of it, it is the overall direction for yields, and with the announcement that QE is about to be reversed, there is only one way yields are going to go in the medium term and that is UP. With the prospects of unavoidable capital losses looming on the horizon, fund managers will not wait for tapering to actually start before offloading positions. They will move as quickly as they can and they did. Any experienced market operator understands that, but apparently there are not many of them at the FOMC.
One may say that we always knew that it would be very complicated to wean investors off the constant injection of liquidity in the system but at the same time we also knew that it would be an issue for the long term… and we will all live and die by performance in the short term.
So, has anything changed? Well, we may not have the luxury to push back into a distant future this issue. Granted, there is no inflationary pressure at the moment, and, as there is still some slack in the US economy, there might not be for a number of quarters. However, Bernanke was right to publicly muse last May about the need to start reversing QE*, because the US economy is firmly on the path to recovery even if the pace of it is currently masked by strong fiscal headwind (costing 150bps to GDP growth, but they are expected to abate substantially next year).
If our prognosis that the US recovery continues and even strengthens proves correct, expectations will be that tapering has to occur and with it there will be further losses for the bond market. If the Fed gets scared again by the rise in long bond yields, it could stop it and even reverse it (QE4?), but then its credibility would be shot to pieces. You cannot announce tapering, witness a broadening of the recovery and then start another round of QE! We should brace ourselves for further turmoil in the bond market, possibly spilling over to other asset classes.
There are mounting signs in Europe that the recession is behind us. All PMI’s have inched above 50, but for France, the new “sick man of Europe”. However, the pace of the recovery will be extremely pedestrian, as most countries are still pursuing fiscal consolidation strategies. Many cyclicals have jumped in anticipation, without much discrimination. There will disappointment on the road for many of them. Our job is cut for us next year: find the ones which deliver the hoped for recovery in earnings.
*Though the actual reversal of QE will take place only when the Fed withdraws liquidity. Tapering is just a reduction in the injection of liquidity, so not an actual reversal, but, as we discussed, the bond market will take this as the initial step leading to ultimately a withdrawal of liquidity and will not wait for the umpire’s starting gun.