So it Begins - Bernanke begins the taper hoping for less of a battle than Helms Deep

                "So it begins!" - The words of the fictional Theodan, King of Rohan at the start of the Battle of Helm's Deep in the epic The Two Towers. One wonders if potential Theodan doppleganger Ben Bernanke was having these same thoughts as he prepared to give the Fed's announcement on Wednesday that the time had come to taper. You can almost imagine him standing there looking out over Wall Street with tens of thousands of orcs (a.k.a traders) preparing an all out assault on bonds and stocks and Bernanke wondering if what he was about to unleash would be the right weapons to save the day. Turning to his fellow FOMC board members - "So it begins".

"So it begins" - Bernanke will be hoping to have an easier ride than Theodan at the Battle of Helms Deep

              And so it does begin. Slowly, a little bit at a time. After the markets original bet of a September start to tapering, Bernanke and the Fed finally began the reduction in the amount of stimulus being pumped into the market by $10bn. Starting in January the Fed announced that the size of the monthly QE stimulus would be $75bn a month ($35bn on Mortgage Bonds and $40bn on Treasuries). Initial market reaction to this was actually positive, a sharp contrast to the original response back in May on the suggestion of tapering. The S&P 500 and Dow Jones raced to fresh record highs up over 1.5%, whilst 5 year Treasury yields closed at 1.63% and 10 year at 2.94% yesterday. Whilst the yield increase represent an upword movement in future rate expectations, it is perhaps smaller than one would have expected given the fear the market previously showed at the mere mention of tapering.

          The positive stock market response and relatively mild increase in yields is a definite positive and reflects potentially a skilled handling of the situation from the Fed's perspective. Markets potentially had been expecting the first taper to be of a more dramatic nature, with some estimates of a $30-40bn reduction being used in the first round. By testing the market with only a slight $10bn reduction in monthly QE, the Fed effectively said we're not going to make you go completely cold turkey. Going back to my previous analogy comparing it to the kid trying to ride a bike, it's as if the child who was so afraid of his parent letting go of the handle bars suddenly realised that even though the parent has taken their hands off the handle bars, they've left the stabilisers still on. The market is now starting to realise that the Fed isn't just going to let go of the handlebars completely without support. Recent predictions since Wednesday's announcement seem to be suggesting that the Fed, under the new leadership of Janet Yellon from January, could withdraw $10bn each month over the next 7 meetings, a gradual, predictable weaning, which would allow the market to digest in an organised manner the consequences and begin to focus properly on the real economy.

        Even with this gradual withdrawal of monthly QE the Fed has also acted to control the further rise of interest rates through increasingly less rigid forward guidance. Whilst previous guidance had the market believing that inflation around and below 2% and an unemployment rate below 6.5% were set in stone levels that would see the base rate start to rise, Bernanke has now sought to further dispel this fact. The latest guidance suggests that rates will remain in the current 0-0.25% band potentially well past the point where unemployment is below 6.5%. This is especially the case should inflation continue to remain roughly half the target of 2%. Analysts now predict that we may not see any rate rises until mid 2015 or even 2016, a far cry from the end of 2014 most were predicting just a few months ago.

                  The beginning of the taper though is good news and the ultimate complete removal of the ongoing stimulus is likely to be beneficial for the economy. There is potential that inflation would not actually begin to rise again until the point that QE is no longer being pumped into the market. Some analysts suggest that far from being inflationary, QE actually is causing there to be less inflation. The inflationary impact of QE has of course been seen in asset prices, but there is potential that this is at the expense of other prices. This is not that I believe that by stopping monthly QE we will see a dramatic fall in asset prices. The approach the Fed appear to have taken by a staggered reduction in the stimulus will allow the market to focus on the fundamentals of the economy and individual company performance again. So long as these continue to grow then there is no reason the stock market cannot continue to sustain the current levels. We are by no means out of the woods yet. The US economy is still only predicted to grow between 2.5-3% over the next couple of years compared to an average of 3.2% coming out of the previous 2 recessions. But this must be put in context of the scale of this recession compared to 1991 and 2001 and the efforts required to ensure it didn't become like the 1930s. If the Fed can maintain what it has now begun, to the point where no additional stimulus is required towards the end of 2014 whilst still convincing the market that interest rates will remain low until that escape velocity is in full force, then it will have done it's job. Right now it seems it may just be succeeding.

       And so it begins. For now the ferocity of the orcs seems quite mild for Bernanke compared to what Theodan faced. Bernanke, and now Yellen (the future Gandalf?), will just be hoping their own Battle for Helms Deep in restoring the forces of order in the market continues along this smoother course than the King of Rohan. They may even be getting the orcs on their side!