The market has been alive with speculation regarding when and how the US Federal Reserve (the Fed) will exit its ultra-loose monetary policy, currently being carried out through near zero interest rates together with direct asset purchases, a form of quantitative easing (QE). The debate was sparked by Ben Bernanke’s response to a question at his testimony to Congress in late May. In his reply Bernanke stated: “If we see continued improvement and we have confidence that that is going to be sustained then we could in the next few meetings take a step down in our pace of purchases.”
This was immediately interpreted as signalling an imminent “tapering” of the $85 billion a month asset purchases and contributed to a sell-off in both bond and equity markets. Since then, there has been a more measured response to the comments and the level of qualification in Bernanke’s remarks underlines the fact that stronger economic data will be necessary to herald a change of stance by the Fed.
In our view, there is a lot of noise as market commentators and Fed members offer their individual views rather than firm guidance. What we do know is that it is logical that one day the Fed will have to stop buying assets. The problem is that the markets have grown addicted to the additional liquidity this has provided and it would be remiss of the Fed to not acknowledge this fact
This probably explains the more gradual approach being put forward. With QE1, the Fed abruptly stopped. With QE2 they slowed asset purchases to zero. With QE3 we are being guided towards a “tapering” approach. What is interesting this time is that the tapering approach could work both ways and Bernanke reiterated this when he said the Fed “could either raise or lower our pace of purchases going forward.”
Despite all the coverage since the testimony, the Fed has done nothing yet, and is unlikely to do so if it looks like markets would crash. Unemployment remains above their 6.5% target, and that is without adjusting for people leaving the potential workforce. Janet Yellen of the Fed set out five measures that form a Fed dashboard for the strength of the labour market, stressing that although the unemployment rate and growth in employment remain key, other factors such as the hiring and quitting rates should also be considered. The 175,000 net new non-farm payrolls figure for May was solid but still shy of the 200,000 that would noticeably accelerate a reduction in the unemployment rate. Further readings in the 175,000 region make a start to tapering in September 2013 possible but far from a given.
What is important is that markets do not lose sight of the fact that tapering is merely a slowdown of the increase in the Fed’s balance sheet. It will still be QE. It will still be accommodative. Moreover, the Fed has committed to keeping the Fed funds rate near zero at least as long as the unemployment rate remains above 6.5% and as long as inflation is no more than 2.5%. Neither of these conditions looks likely to be breached this year.
Europe is not immune to the decisions taken across the Atlantic but it is worth noting that different dynamics are at play and that Europe is at a different stage of monetary policy – it is behind the US. What is more, European bond markets are the lowest duration in the developed world and so are less sensitive to interest rate risk, as reflected in their more defensive movements during May’s volatility.
Overall, we recognise that it will not be easy to withdraw stimulus but markets need not be alarmist. We believe that some of the softness in bond markets in late May and early June reflects a pull back after a particularly strong performance in previous months. If anything, the volatility in the markets could present some buying opportunities, particularly if you believe, as we do, that the underlying economy is still weak, employment remains fragile, and inflation is not an immediate threat.
By Chris Bullock, co-manager of the Henderson Horizon Euro Corporate Bond Fund