Next week, the Federal Reserve might decide it’s time to start scaling back its $85-billion a month bond-buying program, otherwise known as quantitative easing (QE).
Many of us remember what happened the last time Ben Bernanke simply mentioned the idea of phasing out QE. It was the financial markets equivalent of a small earthquake: No major casualties in the end, but when the floor started shaking it sure was pretty scary. In the U.S., interest rates on long-term loans, including mortgages, shot up by a full percentage point over the summer, threatening to choke the one-year-old housing rally. Meanwhile, the prospect of better long-term payback in safe U.S. securities encouraged many investors to pull their money from the rather riskier places where they’d gone looking for decent returns, namely emerging markets. Countries like India, Brazil, until recently the darlings of the market, found themselves battling capital flights and rapid currency depreciation.
So, if merely talking about tapering QE nearly shook the global recovery out of its shoes, could the actual taper unleash some sort of financial tsunami? Luckily, probably not. The real thing will likely cause far fewer tremors than its foreshadowing, for two reasons.
The first has to do with long-term rates. As I’ve written before, investors have had plenty of time to adjust to the prospect of tapering since the T-word started circulating earlier this year. They’ve now tweaked their portfolio holdings, re-formulated their forecasts, re-shaped their strategy. For them, it’s as if the first round of tapering had already happened. There might still be some short-term tremors on the day the taper is announced and shortly after as a few traders try to make money on speculative positions. Likely, though, not much more than that. Likewise, emerging market government have had some time to plan for contingency measures to better contain any capital outflows and reassure investors.
Of course, long-term interest rates will rise in response to additional rounds the tapering — that is, after all, the whole point of tapering — but the adjustment will happen gradually. Analysts I’ve spoken to expect rates to climb another percentage point, but over a much longer stretch of time than what we saw earlier this year.
The second reason not to fret about the first round of tapering is that short-term interest rates will stay at rock bottom for a while longer. That is, of course, what the Fed has been saying all along. The markets, though, initially seemed to misunderstand or disbelieve the central bank, taking the taper-talk as a sign that short-terms rates too would soon rise.
The good news is that they now seem to have finally gotten the memo. One way to gauge what the market expects in terms of short-term rates is to look at Fed Funds future contracts, which allow investors to place bets on what where the federal funds rate will be in the future (This long-term view can influence short-term rates). The trading price for these contracts is based on a 100-point index: It is 100 minus the average value of the federal funds rate expected for the month of the contract (the settlement price for expiring contracts is 1000 minus the effective fed funds rate). For example, below is the chart for Fed Funds future contracts for January 2015. As you can see, their price in early September dipped below 99.475, meaning investors believed then that fed funds rate would climb above 0.525% by January 2015. This week, however, the same contract is trading at around 99.855, meaning investors now expect short-term rates in one year to remain around 0.145%, roughly where they are now.
This is good news. A broad-based belief that short-term rates are going to stay low for some time should keep people borrowing, investing and spending throughout the economy, which is what the Fed wants in order to keep the recovery going.
If the markets’ knee-jerk reaction to the Bernanke’s taper talk earlier this year caught the Fed by surprise, things now seem to be finally falling into the place exactly as the central bank wants. Hopefully, that means smooth sailing ahead.
Erica Alini is a reporter based in Cambridge, Mass., and a regular contributor to CanadianBusiness.com, where she covers the U.S. economy.