When ex-Federal Reserve chairman Ben Bernanke mentioned the possibility of ‘tapering’ the bank’s quantitative easing programme back in May 2013, the first market response was somewhat confused.
US equities sold off and emerging-market equities and currencies plummeted. But, at the same time, despite the apparent shift to ‘risk-off’ mode, long-dated US Treasuries also got dumped.
With hindsight, the corner that was wrong in this odd triangle was the US equities sell-off. The withdrawal of Fed liquidity seemed like a good enough reason to exit Treasuries and emerging market bonds. But the equity market was caught in yesterday’s thinking, convinced that Fed liquidity alone was holding it up and that, therefore, good news on the economy was bad news for risk assets. It realised its mistake on 24 June, bounced – and hardly looked back for the rest of 2013.
Then, on 10 January, we discovered that the US only managed to create 74,000 new jobs in December 2013, a shockingly low number. The last week of January saw equity markets fall over a cliff edge. Emerging markets found new lows. But this time, long-dated US Treasuries rallied hard.
The US equity sell-off fit with a story of an economy failing to achieve escape velocity, as did the rush to Treasuries. Why didn’t emerging markets also reverse their recent trajectory? Because investors have decided that, short of Armageddon, the Fed will be unable to reverse its decision to cut back its balance sheet expansion. Why didn’t that realisation keep Treasury yields elevated? Because with a curve this steep, 10-year yields only had to hit 3% to send the 5Y5Y forward rate up to 4.5%: the 10-year snapped back, not because of the threat of more QE but because the short end is anchored at zero.
But then things did turn odd. With this thesis in place, you’d have been awaiting the 7 February US jobs number, ready to dump your risk assets if it came in anywhere under 150,000. And the print was rubbish: 113,000. In the hour before Wall Street opened, index futures tumbled and so did Treasury yields. And then – panic over. The markets opened in green territory and just kept going. Emerging markets also seem to have staunched their wounds.
Investors must have decided that these jobs numbers don’t carry enough significance to deliver downside risk to markets in the face of so much other healthy-looking data from corporate America, but that they do give incoming Fed chair Janet Yellen just enough comfort on spare capacity to keep short rates at zero for a long time to come. That anchors the 10-year yield around 3%, which has proven to be a sweet spot for US equities.
And the emerging markets?
Fed tapering will force their central banks to respond, as they have already. Given the anchoring of the US curve, that should re-introduce decent rate differentials to attract foreign capital back into their battered currencies. The downside is that this hawkishness will exacerbate the economic slowdown in these regions. Emerging market equities may struggle to rebound to the same extent as local-currency bonds during 2014.