That's the end of QE tapering talk then? Not quite, but it should die down somewhat, give U.S. Fed Reserve conduit Jon Hilsenrath's latest kiss-and-tell article in The Wall Street Journal. Thankfully, it might also stop all the blather about the U.S. and global economies recovering (they're not) and this being the end of the bond bull market (premature). What most investors fail to realise is that developed markets, including the U.S., simply can't afford a normalisation in interest rates: higher rates on government debt would crush their economies. This means QE tapering is highly unlikely and the current money printing experiment will only end when investors lose faith in government bonds. Where getting closer to that end game, but we're not there yet.
If the above is right, we may be in for a prolonged period of volatility where investors expect QE to be cut back, it may indeed get cut back at some point, only to increase again when it's recognised that any normalisation in interest rates will create huge problems. For emerging markets such as Asia, it'll mean increased volatility, although I'd argue the past week's stock market moves are reverting back to normal from an abnormally tranquil period over the past 3-4 years. This will create some opportunities, but be aware that the odds still favour a bond market crash at a later date.
What's behind the past week's action?
What explains the tumultuous market action of the past week? Put simply, there have been escalating fears that U.S. Federal Reserve will cut back on its US$85bn a month stimulus program. This has led to rising U.S. bond yields over the past month, thereby putting upward pressure on yields around the world.
Cutting back on QE would mean reducing the printed money that the Fed has been using to buy bonds. That would result in less liquidity, less money in the financial system. The printed money has helped support asset prices, particularly stock and bond markets. Less liquidity would reduce this support.
Much of the printed money had leaked into areas offering the best growth prospects, primarily emerging markets such as Asia. This led to some spectacular stock market performance, especially in South-East Asia. Naturally, talk of QE cutbacks hit the best performing, less liquid markets such as Thailand, the Philippines and Indonesia especially hard.
Japan is another matter. Stimulus equivalent to 3x the U.S. as a proportion of GDP and an inflation target of 2% has resulted in manic action across Japan's stock, bond and currency markets. The yen has snapped back after being oversold, but remains extremely vulnerable given the stimulus policies of the Bank of Japan (BoJ).
Meantime, Japan's bond market has investors fleeing due to a 2% inflation target almost guaranteeing them large losses and a central bank intent on keeping yields low to prevent interest being paid on government debt spiralling out of control. Investors are starting to realise that the government may not win this battle.
There is an alternative view: that the reason for the recent Japanese volatility is that the BoJ is backing away from its inflation target and stimulus efforts. It's a laughable notion put forward by seemingly respectable commentators (see here). It ignores the fact that if the BoJ's efforts succeed, rising inflation will eventually lead to rising bond yields and interest rates, which will kill the Japanese economy (see here for my previous article on this).
Later in the week, of course, the Fed came to the market's rescue. Via its Wall Street Journal mouthpiece Jon Hilsenrath, the Fed essentially tip-toed back from earlier suggestions that it would soon reduce QE. Here's what Hilsenrath had to say:
"The chatter about pulling back the bond program has pushed up a wide range of interest rates and appears to have investors second-guessing the Fed's broader commitment to keeping rates low.
This is exactly what the Fed doesn't want. Officials see bond buying as added fuel they are providing to a limp economy. Once the economy is strong enough to live without the added fuel, they still expect to keep rates low to ensure the economy keeps moving forward."
Below is the U.S. 10 year government bond yield, courtesy of Yahoo.
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