Rough ride begins

The real questions are whether the Fed is serious about withdrawing quantitative easing and how it will about it
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First Published: Mon, Jun 03 2013. 07 14 PM IST
A file photo of Ben Bernanke. Photo: AFP
A file photo of Ben Bernanke. Photo: AFP
The big issue that has been occupying the minds of global financial market participants lately is the timing of the withdrawal of the additional monetary stimulus that the US Federal Reserve provided last year. It increased the amount of assets it purchased per month from $45 billion to $85 billion and set quantitative targets on the unemployment rate (6.5%) and inflation rate (2.5%) for the removal of its ultra-easy and accommodative monetary policy. Since the official unemployment rate is 7.5% and the reported inflation rate is 1.1%, investors had concluded that Fed was not even remotely close to ending its asset purchase programme.
However, chairman Ben Bernanke rudely shook them out of their complacency last month. In response to a question after his testimony to the joint economic committee of the US Congress, Bernanke told the US Congress that depending on incoming economic data, Fed might taper off its asset purchase in the next 2-3 months. US stocks have been volatile since then and capped their volatility with a big drop on the last trading day of May. Since then, the yield on the US 10-year government note has gone up by about 23 basis points (from 1.92% to 2.15%) and the 30-year mortgage rate has gone up by about 45 basis points (3.65% to 4.1%). Investors are worried.
The real questions are whether Fed is serious about tapering off—reduction or withdrawal of quantitative easing, how will it go about it and its implications for emerging economies. This columnist remains sceptical that the Bernanke-led Fed is serious about ending quantitative easing, partially or fully. Hence, Bernanke might be content to stop with warnings. After all, if it temporarily halted or slowed the relentless rise in US stock prices this year, it is a good thing. It might prevent stock and junk bond markets from blowing themselves up too soon, too spectacularly.
This strategy is risky because Bernanke has tied himself to data now. He cannot avoid following through on his response to the Congressmen, if the US economy creates around 200,000 jobs per month in the next 2-3 months. With the exception of April, the US economy had created around 200,000 jobs in the six months from October to March. Reported job creation in April could be revised higher too.
One of the sharpest minds your columnist has encountered in the past two decades in global financial markets told him on Sunday that not to end the additional asset purchase after recent job creation in the US and after signs of stability in the euro zone will cause bond yields to rise. Acting now will cap the eventual rise. That is what Bernanke is trying to do. In other words, acting now will enhance the credibility of the central bank and that credibility will keep bond yields from rising too much. After all, the yield on the 10-year government bond had risen by about 27 basis points since late April, even before Bernanke addressed the Congress panel.
The problem for Fed is that it has been an overindulgent parent to investors for quite some time. The minutes of a meeting of the federal advisory council (FAC) held in May are rather illuminating in this regard. FAC is a body of bankers from the 12 Federal Reserve districts that consults with and advises Fed in all its functions.
In the May meeting, the bankers noted that student loan balances and delinquencies had continued to rise and that the proposals in the Congress to reduce interest rates on such loans could further encourage student debt and increase the ultimate cost to taxpayers (http://1.usa.gov/11urJG3 ). How interesting. That is exactly what Fed has done in response to the 2008 crisis caused by huge debt. It has lowered interest rates and further encouraged leverage.
FAC also noted that it will be difficult to unwind policy accommodation and the end of monetary easing may be painful for consumers and businesses. In a classic understatement, it noted that uncertainty existed as to how markets would re-establish normal valuations when Fed withdrew from the market since Fed is perceived as integral to the housing finance system, given its balance sheet increase of approximately $2.5 trillion since 2008.
Faced with this huge unknown, investors will typically wish to postpone the reckoning to the future and would be praying for weak job creation in the US in May, due on Friday. That will seal the divorce between Wall Street and Main Street and expose the phantom valuation of US and global stocks. It will prove conclusively, if proof was indeed needed, that the global rally in stocks and junk bonds has been a Frankenstein’s monster created by loose monetary policy.
V. Anantha Nageswaran is the co-founder of Aavishkaar Venture Fund and Takshashila Institution. Comments are welcome at baretalk@livemint.com. To read V. Anantha Nageswaran’s previous columns, go to www.livemint.com/baretalk
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First Published: Mon, Jun 03 2013. 07 14 PM IST
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