What can we infer from the market reaction?
The reaction among fixed income markets has been muted whilst equity markets have risen. Both markets have largely responded positively to greater clarity after several months of “will they, won’t they?” and recognition that tapering still adds liquidity to the system, albeit at a declining pace. If, as suggested in Ben Bernanke’s final press conference as chairman, the pace of $10 billion monthly reductions is maintained, net asset purchases could end by the fourth quarter of 2014. That said, there remains an element of data dependency so markets could yet be sucked back into the vortex of viewing good economic news as bad news in terms of liquidity and vice versa.
The tapering has arrived earlier than expected but there was a dovish corrective to the announcement in terms of forward guidance as the FOMC said it would “likely be appropriate” to hold interest rates at near zero “well past the time that the US unemployment rate falls below 6.5%”. This suggests the 6.5% threshold, although never set in stone is malleable, and the FOMC could be prepared to tolerate stronger jobs growth in the absence of higher inflation.
What is interesting is that the market appears to be giving a reasonably high amount of credibility to US forward guidance. The median projected figure for US interest rates at the end of 2015 from among FOMC members is 0.75%. This is more or less in line with the market’s consensus.
The question is whether the Fed can hold the forward guidance line for long if the economy normalises quicker than expected. As the Bank of England has discovered recently, with UK economic growth and labour market strength surprising to the upside, credibility can be tested if central bank forecasting begins to look poor.
How are we positioned?
We are expecting a flatter yield curve. As a result, the front end (shorter-dated end) of the yield curve looks most vulnerable because the economic data is quite strong and underlying economic momentum is good. It was noticeable that the Fed did not cut interest rates on excess reserves to stop the front end reacting to the tapering announcement. In contrast, we believe the last few months have seen the bulk of the sell-off in longer-dated bonds. The yield on the 10-year US government bond has already gapped out from around 1.6% in May 2013 to around 2.9% in December 2013. At these levels, we believe the market has already priced in a high proportion of the tapering, although with the Fed (a price-insensitive bond buyer) reducing its pace of purchases this may introduce more volatility into the market in 2014. It will therefore be important to be able to have the tools to react quickly.
