As a result, we expect the market to remain benign and favourable to both broader risk assets and emerging markets.
His and hers
Bernanke’s and Yellen’s apparent aim was to start tapering without causing any significant volatility in markets, in particular to avoid 10yr yields jumping higher which would inadvertently push mortgage yields higher, adversely impacting the housing market, consumer confidence and hence risking the stability of the US economy at this delicate juncture.
Our view holds that expectations of tapering were already priced into the market and, more importantly, yields were at fairly-valued levels. Emerging market local currency yields at 6.75% were already at the upper end of the 6-7% fair value range and 10yr yields at 2.85% were already close to their current 2.75% fair-value levels.
With eventual tightening probably still two years away and a clear strategy to manage market expectations, both current Federal Reserve Chairman Ben Bernanke and incoming Chairwoman Janet Yellen want to maintain 10yr yields at or near current fair valued levels. A gradual upward trajectory is expected with 10yr yields moving closer toward 3.25% fair value in a year’s time.
Stability ahead
In our view, Bernanke first mentioned tapering in May not because the US economy was overheating with inflationary pressures, but as a prerequisite for correcting market mispricing in fixed income markets.
Acting as a prudent central banker, he acted “to take away the punch bowl just as the party gets going” and doing so by pricking a potential speculative fixed-income bubble created by hot money and non-dedicated flows into fixed income assets.
In particular, we believe he may have wanted to avoid former Fed Chairman Greenspan’s mistake who, having identified a bubble in 1996 and warning of ‘exuberance’ in markets, failed to take any further action against the market momentum thus causing the bubble to continue growing until the eventual 1999 dot com crash.
In conclusion, our expectations were not for eventual tapering to cause another May correction, given the overvaluation in yields at the time (10yr yields stood at 1.6% and EM local currency at 5.15%). Instead, we believe that this latest tapering announcement looks likely to achieve its aim – to maintain a stable market environment.
