Ultimately, the Federal Reserve will remove its extreme policies of monetary stimulus, because ultimately the US economy will stage a recovery. And ultimately, the remarkable onward march of the US stock market will be thwarted and go into reverse.
The problem is to work out what “ultimately” means, and exactly when these things will happen.
This is the issue of the week, as market watchers get back to parsing the Fed’s words. When the leadership of a central bank changes hands, it takes a while for the new head to work out an idiom with which to address the market.
Jean-Claude Trichet, formerly of the European Central Bank, developed code words, such as “vigilance” to signal what he had planned for the next meeting. Alan Greenspan, of the Fed, opted to speak in Delphic riddles. And Ben Bernanke, soon to leave the Fed, with revolutionary forms of forward guidance, appears to have attempted to tell it like it is – although the shock in September when he opted not to start tapering off so-called “QE” bond purchases, shows that there has still been ample scope for misunderstanding.
What did she mean by this?
At one level this is either meaningless or obvious. Given a strong recovery (and many believe this will not happen), then that would obviously let the Fed stop taking measures that have always been presented as exceptional policies designed to fight a crisis.
In this context, it is not surprising that stocks did well, but rather that bonds did not do much better. Yields, which move in the opposite direction to prices, briefly reached 3 per cent when the market thought tapering would start in September. But although that date has been pushed forward indefinitely, they remain at 2.7 per cent – a full percentage point higher than they were when “taper talk” started in May. Why did bonds not strengthen more? And why did the dollar, which should have been weakened by the Yellen testimony, hold up well?
Steven Englander, Citibank’s foreign exchange strategist, has an answer. Bond traders know that QE is having a distortive effect.
The Fed is set to buy the majority of the bonds that the US Treasury issues next year. Indeed the Treasury appears to be altering its issuance policy to issue bonds with the maturities that the Fed wants to buy. Ms Yellen knows this. The market is quietly betting that QE cannot last much longer.
That implies, if more stimulus is needed, that it will have to come from some different policy. The most likely candidate is more aggressive forward guidance. Ms Yellen might promise to keep rates at zero for a particular time, or cut the unemployment rate – currently 7 per cent – at which the Fed would be permitted to raise rates.
Introducing such a policy would offer plenty of chances for Ms Yellen and markets to misunderstand each other. There is every chance of market turbulence next year once she has taken over.
But until the end of the year, the stock market seems safe. In the short run, it would be unwise to fight the Fed, even though the policy of bond buying must at some point be removed. Ultimately.