This is the first of two posts on the impact of the end of the Federal Reserve’s quantitative easing (QE) program on markets. The recent iteration, QE3, is expected to slow over the next few months. This first article will examine what has happened to U.S. financial instruments and what to expect going forward.
On May 22, 2013, Federal Reserve Chairman Ben Bernanke tapped his microphone in front of a U.S. Congressional testimony and said, “If we see continued improvement and we have confidence that that is going to be sustained, then in the next few meetings, we could take a step down in our pace of purchases.”
With the first hints of ending the Fed’s most recent iteration of QE3 – a combined $85B in monthly asset purchases ($40B in agency mortgage-backed securities, $45B in outright U.S. Treasuries purchases) – a tectonic shift in global markets began. As is often the case, bond markets have led the way ever since late-May.
The blue area on the above chart highlights the performance of the S&P 500 and the U.S. Treasury 10-year note yield between May 22 (when Fed Chairman Bernanke first warned about “tapering”) and June 19 (when the Federal Reserve’s official policy statement suggested that a reduction in QE3 could occur at some point over the next several months.
The area highlighted is important because it frames the QE3 taper conversation in context of a strengthening US economy. After mid-June, US economic data started to disappoint. Ironically, this has been due to…higher yields (interest rates).
Indeed, a stronger U.S. economy prompted the Fed to look to wind down QE3, pushing up yields, which in turn caused the economy to slow down during the summer. Likewise concerns that the Fed has begun to see certain asset classes as too ‘bubbly’ – bonds in particular after the Fed has added over $3 trillion to its balance sheet over the past five years – exacerbated rising yields.
This remains a logical reaction: the largest buyer of U.S. Treasuries the past five years is suggesting that it will reduce its uptake; demand will fall and price will too as a result. Market participants have been simply front-running the Fed by selling their U.S. Treasuries holdings ahead of any official announcement.
Outside of the shaded area on the chart, there is an observable pattern: even as the S&P 500 has scrapped its way back towards all-time highs, it struggles mightily when U.S. yields move higher. Only when U.S. yields have consolidated over several days or weeks since early-July – in particular the U.S. Treasury 10-year note yield as seen on the chart – has the S&P 500 been able to advance. (This link will remain true, even if the Fed chooses not to taper; lower yields will boost stock prices.)
The consequences of the Fed’s plans to reduce QE3 have serious implications for financial markets across the world, not just in the United States. Indeed, other asset classes’ own barometers of risk – in FX markets, the “carry trade” such as the NZDJPY or NZDUSD pairs – are showing signs of increased instability.
The next post on the end of the Federal Reserve’s QE3 will focus on the impact on the “carry trade,” which the New Zealand Dollar finds itself in the crosshairs. We will examine the outcomes for a reduction in QE3 and how it might impact FX markets.