The unintended consequences of tapering

It occurred to me again how nothing seems to pan out the way investors or market commentators expect. The path of this year was simple; the Federal Reserve would start the process of normalising interest rates, initially by tapering the bond purchase program. The impact was hoped (or expected) to be a gradual rise in long dated interest rates. The normalising of rates would bring market corrections and these corrections would be buying opportunities. What I don’t remember is anyone anticipating the tapering would cause capital to be repatriated from emerging markets, and that capital would find its way back into US treasuries and yields would fall, as appears to be the case. 

With hindsight it was obvious in a way, speculators were taking cheap US dollars investing it in higher yielding emerging economies. When the capital started to be withdrawn the trade would need to be unwound. The tapering impact has caused a wobble in developed equities bit not in a manner that was expected.

Everyone assumed as the Fed bond buying was reduced that yields would rise, mainly because that’s what they did last summer when Ben Bernanke first discussed the possibility of tapering. The difference was last summer US treasury ten-year yields were 1.7% not 3% as they were at the start of this year. US treasury yields started to rise last summer, not because Ben Bernanke talked about tapering, but because the US economy was showing signs of recovery. At 3% you receive a real return with inflation at 1.7%, whereas before you did not, making them now more attractive to own. 

Emerging markets remain what they always have been, politically unstable and volatile, more prone to boom and bust than developed economies. On Tuesday it was announced that US GDP for the last quarter of 2013 was 3.2%. China’s economic growth may be slowing from 7.5% last year to perhaps 7% this year. The US economy is forecast to grow at over 3% this year from 1.9% in 2013.  The US economy is roughly twice the size of the Chinese economy. Taking the impact from just those two economies on global growth would mean the aggregate impact is an increase to global growth over last year. In other words the world is in a much better place to deal with a modest reduction in Chinese growth. 

There was another interesting piece of economic data out on Tuesday. If there was one country where you could have expected to see inflation tick up it was in Germany due to its falling unemployment rate. Like recently reported inflation figures around the developed world, Germany inflation came in below expectations. 

I stick to my theory that we are going live in a world of moderate economic growth, (the IMF increased their global growth outlook for 2014 to 3.7% only last week).

Developed markets will start to contribute a greater proportion of that growth, at least for the foreseeable future; inflation will remain subdued and allow interest rates in the developed economies to remain low. This should continue to provide a good backdrop for corporates and hopefully equity markets overall to perform in. With German inflation under control, and the Fed tapering, there is always the outside possibility its ECB’s turn to open up its balance sheet. 

Posted on January 31, 2014 .