Fears of Fed Tapering Overblown?
World stocks were pummeled and the dollar slumped on Thursday as a sell-off on global financial markets in thrall to central bank stimulus accelerated.
European shares fell sharply in morning trading, dropping 1.3 percent after the second biggest fall in Japan's Nikkei in over two years left Asian shares at their lowest level of the year.
Heavy selling hit the dollar, which slumped 2 percent against the yen as investors spooked by the plummeting Japanese stock market unwound hedges. It fell as low as 93.90 yen, its lowest since April 4, giving back almost all the gains made since the Bank of Japan's aggressive monetary easing announced on that day.This transition is not easy nor is it wise to pull back stimulus at this time which is why Fed officials have been careful to avoid the word 'taper' in their public remarks. In her blog comment, Ann Saphir of Reuters reports, To ‘taper’ or not to ‘taper’? Fading the Fed semantics debate:
The U.S. currency dropped to a 3-1/2 month low against the euro before a slight rebound left the common currency buying $1.3350.
The rout has been triggered by noises from the U.S. Federal Reserve, which meets next Tuesday and Wednesday, feeding into feverish uncertainty about the scaling back of its huge asset purchase program.
"The trend is still in principle a sell-off in markets, a sell-off in riskier assets on the expectations that the Fed might signal further readiness to maybe slow down the rate of purchases," said Daiwa Securities economist Tobias Blattner.
"So all eyes are on the FOMC meeting next week. There is very little else that matters at the moment"
In the debt market, German government bonds rose 40 ticks as investors headed for traditional safe-haven paper. The recent selling of euro zone periphery debt also resumed as Italy also saw its borrowing costs rise at an of an auction of 3-year debt though yields at a parallel 15-year sale were little changed.
TRICKY TRANSITION
U.S. stock futures pointed to Wall Street starting in negative territory again after its recent falls.
Gold saw a second day of minor gains, but there was no sign of any rush to buy bullion, and with oil almost bang in the middle of its recent $100-105 range, commodity markets were largely devoid of the drama going on elsewhere.
Emerging markets were taking another pounding though, a pattern that has taken hold as the uncertainty about central bank stimulus has driven a global dash back to cash and core economies.
Emerging equities fell to 11-month lows and most emerging currencies remained under heavy pressure with the Indian rupee falling to a record low.
The punishing sell-off in Asian markets saw many of them plummet to multi-month lows as investors scrambled to recalibrate positions for a world with potentially reduced liquidity support.
Both the dollar/yen and the Nikkei fell below the Ichimoku cloud bottom for the first time since their rallies began in November, sending a strong bear market signal. The Nikkei also breached its 50 percent retracement from its November rise.
"If you look at it historically, there has never been a period when the Fed has started to take back stimulus that has left the markets untouched," said Hans Peterson, global head of investment strategy at Swedish bank SEB.
"And this time it is a bigger exercise. We have moved markets from 2009 to 2013 on stimulus and now we are trying to take a step into a world which is more driven by natural growth. That transition will not be easy."
Is Federal Reserve Chairman Ben Bernanke avoiding the word “taper” in order to temper expectations that the U.S. central bank will ratchet down its massive bond buying program? This is one view that’s been widely bandied about in recent days.With inflation at a 53-year low, Bullard is right to be cautious on tapering. He has expressed concern since 2010 that disinflation is indicating a lack of demand that will trigger a cycle of falling prices and spending declines like the one that has afflicted Japan for 15 years.
But then why is it that the Fed officials who are most eager to “taper” have pretty much stopped using the word, too?
The last time Dallas Fed President Richard Fisher used the “T” word in a public speech was in February. But there’s no evidence at all that he’s backing off from his support of the idea. He’s been adamant the Fed should not yank the punch bowl away (or, in his words, go from Wild Turkey to cold turkey) but should gradually reduce stimulus.
Likewise, Philadelphia Fed President Charles Plosser last used the word in a public speech two months ago. Since then he’s leaned more heavily on “dial back” or “gradually unwind” but still means the same thing. Another supporter of tapering QE3, Richmond Fed President Jeffrey Lacker, has similarly changed up his verbiage, but not his views.
In fact, the only top Fed official who regularly uses “tapering” these days is one who pretty much thinks it’s too soon to touch that $85-billion-a-month dial. “I’d like to see some reassurance that this (low inflation) is going to turn around before we start to taper our asset purchase program,” St. Louis Fed President James Bullard said earlier this week.
Matthew O'Brien of the Atlantic wrote an excellent comment, The Biggest Economic Mystery of 2013: What's Up With Inflation?. He looks at money printing vs. austerity and concludes:
-- Is it the austerity, stupid? That giant sucking sound you hear is the government taking demand out of the economy. As you can see on the left axis above, total government spending -- that is, federal plus state and local -- as a percent of potential GDP has been on a steady downward trend since 2010. It's a three-act story of bad policy. First, the stimulus peaked, and then reversed prematurely; then, state and local governments began slashing budgets to balance them as they are required; and now, the federal government is cutting spending in the dumbest way Congress could come up with -- the sequester. Now, QE2 did manage to increase inflation despite some austerity, but there's more of it this time around. The chart above only shows total spending through January 2013; it doesn't include the sequester, or, for that matter, the tax side of austerity. Between the spending cuts and the expiring payroll tax cut, the fiscal contraction the past six months has probably overwhelmed any "money-printing".Dealing with austerity isn't just the Fed's problem but it seems to be fighting a lonely battle, especially when you look at the response from Europe's monetary authorities. Desmond Lachman of the American Enterprise Institute notes without bold action from the European Central Bank, it is difficult to see how the European periphery can avoid sinking ever deeper into economic recession in the months ahead:
But the mystery of our falling inflation rate should make one thing less mysterious: when the Fed will start tapering its bond-buying. The answer is not anytime soon. Yes, 5-year breakevens show that expected inflation is still close to target, but as long as actual inflation is so low, the Fed will not ease off the accelerator. That was Bullard's recent message, and he told me he'd like to see inflation get around its 2 percent target before he'd be comfortable reducing the Fed's monthly bond purchases.
Now the Fed just has to figure out how to increase inflation in an age of (bigger) austerity.
Despite this downbeat assessment of the European economic outlook, the ECB was not prompted to act at its last policy meeting. Nor was it prompted by the fact that core inflation in Europe is now down to barely 1 percent, around half the ECB’s inflation target of “close to but below 2 percent.” Instead, the ECB decided to keep its policy interest rate unchanged and it eschewed any notion of joining the Federal Reserve and the Bank of Japan in another round of quantitative easing.The lack of bold ECB policy action is another reason why I don't see the Fed tapering next week or any time soon. In fact, if inflation expectations decline, I wouldn't be surprised to see the Fed step up its asset purchases in the future.
More troubling than the ECB’s decision not to reduce interest rates is its seeming indifference to the fact that bank credit continues to be cut in the European periphery and that private sector borrowing costs in the periphery remain much higher than in Europe’s core countries. While the ECB recognizes this problem, it takes the view that the primary cause is a shortage of bank capital in the European periphery, which the ECB considers to be beyond its remit. The ECB also doubts the effectiveness of buying asset-backed loans of small and medium-sized enterprises in the periphery, as is now being recommended by an increasing number of private analysts.
A generous assessment of the ECB’s present passive monetary policy stance in the face of a rising risk of a European deflationary trap is that the ECB might be reluctant to be too bold at this stage in the German political cycle. Germany, which is the ECB’s primary shareholder and has a traditional antipathy to monetary policy activism, is scheduled to hold elections on September 22 and the ECB might not want to insert itself into that election.
Meanwhile, the German constitutional court is presently considering the merits of a petition claiming that the ECB’s Outright Monetary Transactions (OMT) program is inconsistent with the German constitution’s limits on the Bundesbank’s participation in that program. The petition points out that the OMT program envisages that the ECB could buy unlimited amounts of Italian and Spanish government bonds with maturities of up to three years in order to keep government borrowing costs for those two countries at reasonable levels. Perhaps, then, it is understandable that the ECB is taking the view that it might be better to wait for a more propitious moment in the German political cycle before risking a renewed German controversy on any new ECB policy initiative.
While discretion might be the better part of valor for the ECB, it is not without its costs. Absent bold ECB policy action to get bank credit flowing again and to reduce private sector borrowing costs in the European periphery, it is difficult to see how the periphery can avoid sinking ever deeper into economic recession in the months ahead. After all, the European economic periphery is still being required to implement budget austerity, albeit at a more moderate pace than in 2012, within the straitjacket of the euro. And it is being required to do so at the same time that its external economic environment is deteriorating and that the euro is appreciating against the currencies of Europe’s main trade partners.
The ECB’s present passivity in the face of a distinct deflationary risk could complicate the European debt crisis. A prolonged period of deflation would make the European periphery’s efforts to restore order to its public finances all the more difficult since it would increase its real borrowing cost. Given the fact that countries in the European periphery are flirting with deflation if not already experiencing it, the ECB would be ignoring the risk of a deflationary trap for the European periphery at its peril.
A clear lesson from Japan’s two decades of struggling with deflation is that a central bank pays a very high price for falling behind the policy curve. Hopefully, that lesson will not be lost on the ECB and it will become more proactive in its policy decisionmaking once the German elections are out of the way.
Inflation is a lagging indicator but given record debt levels and the danger of sliding into a protracted period of debt deflation, the Fed will continue to err on the side of inflation. I believe it's only a matter of time before the ECB joins the Fed and Bank of Japan in fighting the spectre of deflation.
Finally, it's important to note the rolling back of the U.S. Federal Reserve's massive quantitative easing program could be a major issue for all economies, according to former World Bank President Robert Zoellick, who says the move would force countries to look at fundamentals for growth:
"[Fed] tapering is a big issue. I think for all economies - U.S., Europe, China, Southeast Asia - the fundamentals still go back to structural reforms," Robert Zoellick, Distinguished Visiting Fellow at the Peterson Institute for International Economics told CNBC Asia's "Squawk Box" on Tuesday.The global repercussions of Fed tapering were discussed in the Economist:
He added that "The question will be as the Fed eventually moves away from the monetary easing policies, what will be the effect of the [withdrawal of the wall of money that's moved around the world?"
...Zoellick, who served five years as the president of the World Bank up until 2012, said there's been a big structural shift in emerging market economies, which used to depend on strong U.S. demand for their products.
"In the past when you had a U.S. recovery that boosted some of the exports... [Now] you've got a movement to more domestic demand - it's going be less export led growth, and that's obviously the huge story for China's change under the new leadership," Zoellick said, referring to the Chinese government's push towards consumption led-growth.
In Japan, recent monetary and fiscal policies that have spurred optimism in the economy could just be a "sugar high" unless the government really invests in the "so-called" third arrow of structural reforms, Zoellick said.
"The danger is in the past sometimes Japan just used currency devaluation to help its export sector, and when I worked with the Japanese 20 years ago... Japan never was really willing to open up its services market and other areas that would increase productivity - that's the third arrow," Zoellick said.
Researchers at Barclays Capital have looked at which assets are most sensitive to the Fed’s balance sheet, by dividing the change in the asset prices over periods of QE, by the change in the size of the Fed’s balance sheet. At present, markets are adjusting to the Fed’s balance sheet merely expanding more slowly than expected. At some point they will have to adjust to its outright shrinkage.
Since emerging-market equities and European and American high-yield bonds showed the greatest sensitivity to Fed balance sheet expansion, they could be expected to also fall most when it shrinks. Judged by how an asset deviated from its historical value during QE, Turkish equities and "defensive" stocks (those that do not move with the business cycle, like food) are most vulnerable (click on image).
Any tapering in the Fed’s $85 billion-a-month asset-purchasing program will hurt economies in Europe and Asia, where the focus remains on loose monetary policy, Stephen L. Jen and Joana Freire of London-based hedge fund SLJ Macro Partners LLP wrote in a June 10 report. This decoupling would particularly strike emerging markets, which previously served as magnets for capital as the Fed kept monetary policy looser than their central banks did.
Now think about what will happen if we get a crisis in emerging markets because the Fed starts tapering. It will only reinforce global deflationary headwinds, which is exactly the opposite of what the Fed and other central banks want.
For this and other reasons I've outlined above, I just do not see the Fed tapering any time soon. If they do, they will spark another global financial crisis at a time when the world is still dealing with the effects of the last crisis. Moreover, the spectre of deflation lingers, posing a real threat to the global financial system and to pensions preparing for inflation.
Below, Robert Zoellick, Distinguished Visiting Fellow at the Peterson Institute for International Economics says economies will need to look at fundamentals for future growth as the Fed withdraws its monetary easing.
And Paul Hickey, co-founder at Bespoke Investment Group, talks with Betty Liu about why the market doesn’t need to fear the Federal Reserve tapering QE any time soon. He speaks on Bloomberg Television's "In The Loop."
Finally, Ed Dempsey, CIO of Pension Partners, discusses QE, tapering by the Fed, ATAC, and more with Carrie Lee. Dempsey speaks of how the rise in bond yields has hit emerging markets hard and how disorderly expectations of Fed tapering can lead to more volatility and adverse events.