Markets wobble as policy crutches removed

Every big party eventually fizzles and this week the US Federal Reserve took a major step in signalling the good times for investors look numbered.

For some six years, markets have relied on the Fed keeping its policy punchbowl overflowing with ultra low interest rates and bond purchases so as to foster animal spirits and fire up the economy.

Now the punchbowl is not only being drained, it could well be taken away as the central bank this week formally called time on quantitative easing and signalled how an improving labour market heralds a tightening of interest rate policy next year.

All of which raises the prospect of heightened market volatility as investors focus more on fundamentals for equities, bonds and the US dollar, now that central bank liquidity no longer supports all asset prices.

"Markets have to stand on their own two feet," says David Ader, strategist at CRT Capital.

Tad Rivelle, chief investment officer at TCW, says capital markets have long operated under the belief that the central bank will always provide a backstop.

"That is a very dangerous way to invest for the long term," he says, adding asset prices face a period of repricing now that QE has ended.

Designed to invigorate the economy, the large scale buying of Treasury and mortgage debt has certainly helped pump up asset prices for equities, credit and real estate. The S&P 500 alone has surged 230 per cent, including the reinvestment of dividends since March 2009, while the risk premium for junk bonds remains very low.

In terms of the economy, however, the picture has been mixed. This reflects how the Fed's massive purchases of bonds have ended up as excess reserves held by banks, which have not necessarily used the money to fund loans and investments across the broader economy, thereby stimulating demand and arousing inflation.

As the QE era ends the outlook for the economy remains unclear, with different parts of the market reflecting a large divergence in opinion among investors. While equities and junk bonds remain at rich levels and await vindication in the form of stronger growth, US Treasury yields are low - suggesting the economy is bumping along and looks vulnerable against the backdrop of slowing global activity.

"We've run the course of QE and the animal spirits may sense that the hope and cash provided by the Fed will diminish," says Mr Ader. "For all the Fed's efforts, the economy has not reached escape velocity and certainly the low level of Treasury yields reflects doubts about the outlook."

The end of massive bond purchases has been well telegraphed with a steady reduction in buying since January, leaving markets focused on when the central bank will finally lift its key overnight rate, which has been anchored near zero per cent since December 2008.

Alan Ruskin, strategist at Deutsche Bank, says market volatility will turn on how long the Fed's interest rate policy remains stuck near zero.

"The performance of markets will be contingent on whether a rate hike occurs relatively quickly after QE ends, or comes after a lengthy period of time. If Fed tightening is perceived as not arriving for at least another year, market volatility will be contained."

For now the prospect of rate hikes arriving in the first half of 2015 have been extinguished, with the bond market pricing a modest rise towards the end of next year. This comes after the spectacular spasm of market volatility in mid-October, reflecting a massive liquidation of rate hike bets over the next three to five years.

Any pick-up in economic activity and signs of inflation turning higher will trigger a new round of rate hike bets for 2015, and this week the Fed's upbeat policy statement pushed markets a little in that direction.

But investors are still waiting to see whether the economy has legs in the absence of QE, with the recovery in equities and junk bonds since mid-October a function of investors betting that rate increases stay off the table for some time.

Moreover, the message from a 10-year Treasury yield of 2.3 per cent is that any forthcoming rate-rise cycle may be limited in scale compared with prior periods, and could thus limit the fallout across markets.

Rick Rieder, chief investment officer of fixed income at BlackRock, says: "We're encouraged to see the Fed begin to acknowledge that the time has come for something resembling more normal rates, yet while we think the Fed can step off the zero bound now, the pace of normalisation and the ultimate destination of rates are likely to be slower and lower than in past hiking cycles."

Conversely, falling energy prices and declining inflation along with modest wage gains could anchor long-term bond yields at low levels and reduce the prospect of rate rises during 2015.

And for all the worries about the Fed now looking at ending its near zero rate policy, an adverse market reaction could force policy makers to blink.

"The Fed is trying to reduce excesses in credit markets and if the reaction is too negative, it will likely keep rates lower for longer, a policy that by itself carries significant risks," says Mr Rivelle.

© The Financial Times Limited 2014. All rights reserved.
FT and Financial Times are trademarks of the Financial Times Ltd.
Not to be redistributed, copied or modified in any way.
Euro2day.gr is solely responsible for providing this translation and the Financial Times Limited does not accept any liability for the accuracy or quality of the translation