The BIG Hoo-Ha on FED’s planned Tapering of Quantitative Easing

 

The US Federal Reserve Open Market Committee’s announcement on lowering the amount of monthly bond purchases or in other words tapering of the existing level of quantitative easing (QE) has got the financial markets animated in a big hoo-ha causing volatility. And the financial media has been inundated with commentaries on various plausible scenarios. To understand possible outcome and where the economy could be heading, we will need to start with where it is today. And here is something interesting, in over last 10 months US treasury’s overall tax revenues collection was around $ 4.3 trillion, a jump of nearly 15% from the same period last year. According to the Congressional Budget office ( CBO ) projection the US government budget deficit for the Fiscal Year (FY) 13 is estimated to be around $ 642 billion, a decline of over 35% from last year and because of the sequester related spending cuts the deficit is projected to be around 4% level for FY 13 and may fall further to around 2.1% in 2015. Also the recently revised data suggests that US economy grew at an annualise rate of 2.5% for the period April – June 2013. So clearly the US economy is getting healthy and probably entering an expansionary phase but having said that going forward we may still see mixed data and the reason being, the existing high level of external support from the FED to boost  growth.

The Federal Reserve has been acting as the BOOSTER engine supporting the economy and only after the withdrawal of this anchoring support we will get a clearer picture of the health of the economy. Various policy measures or tools have acted as a cocktail of drugs loaded with steroids to help the patient ( the economy ) fight the fatal infection and by all accounts it is quite evident that the world economy ( the patient ) today is not in intensive care and the recovery is gathering pace hence lowering of the HIGH dosage should be considered as a natural course of action. But this proposal of lowering of the high dosage of  drugs by a way of tapering  the current level of quantitative easing ( QE) has caused panic in the market and created volatility hitting the emerging markets the hardest. And since the announcement of QE tapering in June of 2013 a whopping US 1.4 trillion in value has been erased from emerging market equities. The markets have recovered somewhat in the last few days of August but given the uncertainty over the monetary policy exit and geopolitical risk to a certain extent the volatility isn’t going to go away tomorrow. And this is why the global economy needs a smooth transition and not an abrupt or sudden change of gears.

By announcing the planned proposal to start tapering of quantitative easing (QE) from the existing level by a way of lowering the amount of monthly bond purchases, the FED is more or less lowering the current high dosage of antibiotics and cocktail of drugs (steroids) that it thought was essential to fighting the fatal infection during the financial crisis. The temporary policy measures or in other words the current prescribed course of medication has to end sooner rather then later as there is a serious risk of overdose so like a good doctor, the FED has to trust the immune system of the Patient ( the economy ) and allow it to slowly take over the recovery process.

And with regards to the exact timing though Mr Ben Shalom Bernanke as a part of his forward guidance strategy has linked the start of the QE tapering process to Key economic data and the overall US economy reaching certain milestone, the announcement has created a level of uncertainty in the market and there are already a number of projections on the time line, amount or level of tapering as well as possible outcome for the global economy. The debate will most likely continue going forward but it is safe to conclude that Bernanke & Co won’t be rushing into the process without being sure about the health of the economy and the strength of the overall economic data including of employment numbers among others. Also the central bank ( the Federal Reserve System ) does risk losing serious money on its overall assets holding in the existing volatile market environment related to concern over tapering as well as the ongoing geopolitical situation.

The other interesting event which may influence FED’s decision is the treasury secretary Jack Lew’s recent announcement regarding US government borrowings reaching the congressionally imposed limit on federal debt ( debt ceiling) of $ 16.7 trillion around mid October of this year. This will have an impact on treasuries considering the fact that August was a tough month for US treasuries and other fixed income assets. In the month of August bonds funds have lost over $ 30 billion. Also foreign holders of US treasuries are  becoming increasingly concerned, China recently sold around $ 20 billion worth of US treasuries and others may follow suit driven mainly by concern over Fed lowering the amount of monthly bond purchases under its planned QE tapering, pushing the yields higher. A sudden rise in borrowing cost may be damaging for the economy especially when the economy has just started to gather pace.

The uncertainty is obviously not helpful for the market but a forward guiding strategy deployed by the FED primarily aimed at giving some level of certainty to the market especially on policy measures has clearly created more questions than answers in this case as evident from the existing volatility. However, there has to be a clear understanding that the existing policy measures were designed to be temporary and a tapering of the current level of QE isn’t going to kill the global economy or emerging markets for that matter. What quantitative easing (QE) did is provided cheap and easy money and this HOT money flow drove the asset valuation in most emerging markets to a bubble territory level.

During the crisis, the policy makers across emerging markets were happy talking about the shifting of the paradigm and how well placed their respective economies were but the easy money caught them napping as most of them got complacent and are now paying the price for not being proactive and failing to prepare for a post crisis world. This should serve as a wake up call for the politicians and policy makers in the emerging market. Only last year the financial media was full of sound bites on how US is starting a currency war by doing more QE and today when most EM currencies have depreciated heavily and the economies have started to struggle somewhat, the sound bites have changed. The concern over tapering is understandable but it is highly unlikely that emerging market ( EM ) economies will start to fall like dominoes cause of QE tapering. And the reason being, there is no solid evidence to suggest that hot money directly financed the economic growth across emerging markets, quantitative easing has had a significant impact on the overall valuation of the financial assets but not on the real economy. In fact, the outflow of hot money will most likely diffuse the built up asset bubble making the EM assets look more attractive to value investors. Also the investors will need to realise that the global economy is more interconnected then ever before so at some point before getting into a panic mode or jumping ships they should have a sit down and think their strategy through with a clear mind without getting bogged down in non stop sound bites.

Many in the market projected that a break up of the European Union was more or less imminent but it didn’t happen then there were projections about China falling but again it hasn’t fallen and now some are projecting of an imminent crisis brewing in the emerging markets. The projections and the sound bites are part and parcel of the financial market and navigating through them will always remain a challenging task. But investing isn’t a quick 100 metre sprint or about winning one lap, it’s a long marathon and thats what people fail to realise.

The economy and financial markets are human ideas and not an exact science so the human element will always be a key influential factor. The inherent human nature and desire to make a quick BUCK by using any means has lead to downfall of the financial market on many occasions. And the lesson is in history.

Based on the available historical data, the first recorded financial market crash happened over 300 years ago. The modern financial system as we know it today saw its first stock market crash around 1901. Then the panic of 1907 triggered the creation of the Federal Reserve System and after a relative boom period, the markets crashed again in 1929 causing the Great Depression. But the markets recovered from the Great Depression crashing again in 62 then peaking and crashing back again around 1974. After going through a down time the recovery gathered pace from 1975 onwards but then the markets crashed again in 87. So the story of Boom & Bust goes on. The volatility and periods of BOOM followed by a BUST aka ” Boom-Bust Cycle ” is inherent to the financial market and not a new phenomena and almost all the BOOM and BUST cycles were predictable and caused by the human elements influencing the market. So in the case of financial market history does keep repeating itself and in all likelihood the financial crisis of 2007-08 isn’t going to be the last recorded and reported crisis in this history of humanity.