After he merely raised the issue of tapering off the Fed’s massive monetary easing at some distant point in the future, Ben Bernanke has taken a lot of blame for the renewed rout in the markets. Globally, stocks and bonds are down while currency markets are roiling. But perhaps he’s taking more blame than he deserves.
First, the reason that Fed officials can even bring up the idea of tapering in the first place is that their goals are being met: growth prospects are improving and the Fed must be welcoming the strength in the housing market with a huge sigh of relief â€“ just this morning, new homes sales and Case-Shiller home prices both hit cycle highs. While the economic recovery still has a long way to go, bond markets are pricing in stronger growth. Since early May, nominal 10-year Treasury yields have moved up from 1.6% to 2.6% over the past three months, breakeven inflation rates in the TIPS market have gone the other way, from 2.3% to 1.9%, pushing up annualized real growth expectations. Recent turbulence aside, the trends are clear.
Second, there are many other factors behind the market’s recent gyrations. The global sell-off in bonds really started in Japan, when yields started heading up in early April as the implications of the Abe Trade began to be priced into the bond markets. China is trying to find the right balance between digging out the rot in its financial system and supplying enough credit for the real economy, so far with uneven success. Europe is still Europe. Meanwhile, global riots have broken out from Brazil to Turkey and Indonesia. There’s been plenty of kindling for a spring sell-off, even without the Fed.
Finally, despite all the talk of tapering, the reality is that the Fed is still going full steam ahead with QE3. The Fed funds rate is still effectively zero and the Fed’s balance sheet just hit $3.5 trillion dollars and counting. Even if the Fed starts to curtail its bond purchases, it will merely be slowing the pace of monetary easing. It will be a long time before the Fed gets back to neutral, never mind starts outright tightening. The high-water mark of global liquidity has yet to be reached.
In the meantime, easy money from the Fed continues to flow along with most of the world’s major central banks. Bonds should continue to suffer: real growth expectations are already stronger and eventually we think higher inflation will follow, lifting bond yields and further depressing prices. Stocks can resume their rally after higher bond yields sinks in and analysts adjust their models: stronger growth means stronger earnings than are currently expected. As the global economy returns to normal, differences between countries will be decisive. Just as the notion of the BRICS has broken down, it is the variations within emerging markets and developed markets that will be key.
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Warren Hatch, PhD, CFA
Chief Investment Strategist
McAlinden Research - a division of Catalpa Capital Advisors, LLC