Diverse Responses to Fed Tapering

September 13, 2013

By September 18 when Fed Chairman Bernanke is expected to defend a decision to reduce Fed asset purchases, financial markets will have had roughly four months to get comfortable with that shift.  Bernanke prefers to avoid market surprises, so it’s doubtful that investors will get significantly different news from the guidance of the past four months.  What markets did these past few months is likely to be close to how they will react after Wednesday’s FOMC meeting.

  • Long-term U.S. interest rates were already off their lows when he first floated the likelihood of the action and have subsequently gone up more sharply than envisaged.  The ten-year Treasury yield was 2.04% on May 22, 2.35% a month later when the plan was clarified to indicate an assumed 7.0% jobless rate by mid-2014 when quantitative easing will end altogether, and 2.90% now. 
  • U.S. share prices are generally unchanged from May 22 closing levels of 15,307 on the Dow Jones Industrials and 1,655 in the S&P 500.
  • Several emerging market currencies — those associated with significant current account deficits — have been hammered, prompting a selection of central banks to take various steps including higher interest rates to counter depreciation.
  • Dollar/yen, which had already strengthened through the key 100 threshold by the time of Bernanke’s initial hint of reduced quantitative easing back in May, subsequently see-sawed between 93.79 and 103.74.  It’s average value over this span has been 98.72, and it also is marginally softer than 100 at the moment.
  • The annualized rise of the Chinese yuan since May 22, 0.6%, has not been meaningful and frankly a bit surprising since August saw China’s trade surplus hit a seven-month high of $28.52 billion.

The euro has shown unexpected resilience.  The dollar’s most influential bilateral relationship involves the common European currency, and the performance of EUR/USD tends to be a barometer of overall sentiment toward the U.S. currency.  On balance, recent news from the euro area should have complemented the potential dollar lift of a less accommodative U.S. monetary policy.  True, Euroland’s recession ended in 2Q13, but the region’s recovery looks fragile.  Banks in the area are still saddled with unsustainable debt, and unemployment hasn’t begun to recede.  At their early July meetings, both the European Central Bank and the Bank of England adopted forms of forward guidance that stressed the likelihood of interest rates remaining very low for quite a while longer.  As Germany’s parliamentary election on September 22 nears, hope has faded that the event will mark a flashpoint to be followed by much more regional cohesion over such matters as forging a banking union of shared resources and risk management.

If post-FOMC performance is likely to resemble what’s come before, it’s a fair question to ask why the euro isn’t weaker already.  On the contrary, it’s trading 9.5% above its lifetime mean against the dollar and merely about 1% shy of its best level in 2012. 

Five themes spring to mind.  First, the dollar’s long-term track record isn’t inspiring.  There have been only two periods of multi-year appreciation since the devaluation of 1971: the early 1980s and the late 1990s.  Second, a chronic U.S. current account deficit remains substantial at more than 2.5% of GDP.  Current accounts are arguably the most under-appreciated determinant of currency trends.  That property is what separates emerging markets that have seen steep currency depreciation in 2013 from those whose currencies are showing greater resilience.  Third, investors are unconvinced that the Fed should be trimming its stimulus just yet.  The decision seems to be motivated by mounting FOMC concern that quantitative easing is damaging the financial system infrastructure and promoting future asset bubbles.  On the matter of U.S. economic trends, the jobless rate has fallen for the wrong reasons, inflation remains contained, and average monthly growth in jobs is worrisome of 160K over the latest six months versus 207K in the previous half year.  The rumored controversial choice of Larry Summers to chair the Fed Board of Governors is probably creating additional anxiety.  Fourth, Obama’s presidency has a tired image.  Policy on Syria was handled sloppily, and a big fight with Congress looms next month over raising the U.S. debt ceiling.  Fifth, although Euroland economic news remains troublesome and punctuated with negative surprises like a 1.5% drop of industrial production in July reported yesterday, the improvement in British economic data is more convincing and impressive.  U.K. news enhances the image that Europe’s economy as a whole is reviving.

Copyright 2013, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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