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July 15, 2013

Chart of the Week: US tapering: we are all in it together

by Fathom Consulting.

On our central view, the US economy can handle a modest tightening of monetary policy. But while the US may be ready for tighter monetary policy, the rest of the world is not.

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Asset prices are more correlated under QE than in normal times, and the spike up in yields that followed the FOMC’s June meeting has not been confined to US Treasuries. Sovereign yields have risen across Europe, causing both the Bank of England and the ECB to fight back, issuing ‘forward guidance’ in an attempt to convince markets that policy rates on this side of the Atlantic will be on hold for a very long time. And equities have suffered. Worst hit to date have been the emerging market indices, which benefitted greatly from the ‘search for yield’ that took place during the period of exceptionally loose monetary policy.

The consequences for the rest of the world of a slowdown in the rate of asset purchases by the US Federal Reserve are very different from those of an increase in the Fed Funds rate. This is not a normal tightening. When the Fed does taper there will be a reduction in the prices of many assets, and not just those denominated in US dollars. Indeed, that reduction is already underway.

It was always meant to be like this. QE is designed to work in just this way. In purchasing US Treasuries, the Fed reduced the quantity of risky assets in the hands of the private sector, or so the argument goes. Under the Portfolio Balance Channel, often cited by policy makers as the primary route by which QE influences financial markets, and therefore the wider economy, this should have caused the prices of all risky assets to rise, and not just the price of US Treasuries. That is perhaps why we have seen a greater‐than‐usual degree of correlation between sovereign yields in the major economies during the period of QE. But if the Portfolio Balance Channel works on the way up, it will work on the way down too. When the Fed tapers, and when it sells, there is likely to be considerable upward pressure on yields around the world.

That provides the motivation for last week’s European Independence Day. On 4 July, both the ECB and the Bank of England, under newly‐appointed Governor Carney, used forward guidance in an attempt to talk down long‐term yields. ‘The Fed may be looking to tighten policy in the not too distant future, but we most certainly are not,’ was the clear message on this side of the Atlantic. To the extent that central bankers around the world are able to use forward guidance to influence market expectations of their own future policy rate then of course they retain some control over the shape of their own yield curve. Nevertheless, what lies beyond their control, is the size of the risk premium that drives a wedge between the average expected future policy rate and the yield on government debt. In our view, the Fed has a large part to play here. When the Fed tapers, sovereign yields will rise across the board. Old correlations will out.

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