Global markets have been on a slow (or in the case of emerging Asian markets quite fast) downward trajectory over the last week or so as the world gets itself into a panic that the Fed might be beginning to taper. I've discussed before the seeming irrationality to most of us of this flight from risk at the precise moment when the Fed is indicating to us that the life support will only be reduced on signs that things are recovering. And as more good news from the US seems to indicate that the tapering might start as soon as September, global equity and bond markets have seen a flight out of these assets with the fear of what might happen next seemingly reducing investors appetite for risk.
In my first post a couple of months ago, I raised the possibility of whether central banks had created an inescapable cycle. I questioned whether the low interest rates and QE stimulus had driven the equity market rise, and the possibility that any removal of this stimulus could lead to a fall in these global markets with a potential impact on the real economy as a result, thus forcing a return to further stimulus measures. This seemed to show some elements of truth based on the market reactions to Bernanke's various comments on tapering and following positive economic news in the US, with global market sell offs at each point.
The popular theory at the moment is that the tapering by the Fed is going to begin in September, especially with the encouraging GDP and job figures over the last few weeks. The market, anticipating this, has seen 10 year US treasury yields up at 2.88% and a fall in the S&P 500 and other stock markets around the globe. However whilst the fall in equity markets in emerging economies such as Philippines, Thailand and Indonesia has been quite significant, the S&P 500 currently only sits 3.8% below the high of 1,708 at 1,645 (as of last night's close). To put this in perspective, this is still 4.5% higher than the level when the market fell shortly after Bernanke gave his speech clarifying his forward guidance policy. So despite the market knowing that tapering was coming, and the feeling that it was likely to begin in September for some time, equity markets in the developed western economies are above the level they were at immediately post the initial announcement.
If we work on the assumption that equity markets have already priced in what they know or believe, then the effect of the reduction in QE being used in September should already be reflected in the prices. This is not to say that the market won't react negatively when it happens, but the last few months seem to have demonstrated that once the market digests the news, it will then continue to climb based on the underlying economic fundamentals. These economic fundamentals are, improving GDP growth figures in the US, UK and Eurozone and improving, albeit slowly, unemployment figures in all 3 regions as well. Perhaps the use of forward guidance has already enabled the market to adjust to what is going to happen in the near future, and after the initial panic, the correction appears to reflect the real economic improvement in the economy. If this is the case, then forward guidance is doing it's job. The market is preparing itself already for a reduction in the stimulus, therefore the shock effect when it does actually occur is likely to be less. Assuming the real economy continue to improve as they are at the moment, then the equity market will continue to move forward.
Many market commentators are wary of forward guidance, stating it is madness to give firm figures in advance to the market. But if the market has already priced in slowly the effect of a reduction in QE, then from Bernanke's perspective if this be madness, there is indeed a method in it. That method may well be working, but I guess we'll only really find out soon.
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