Fed sends tough message to markets with taper talk

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SummaryFederal Reserve officials were clearly taken aback by the selloff that was unleashed in global financial markets when the central bank’s chairman, Ben Bernanke, warned that the Fed’s bond buying would likely be scaled back this year

Federal Reserve officials were clearly taken aback by the selloff that was unleashed in global financial markets when the central bank’s chairman, Ben Bernanke, warned that the Fed’s bond buying would likely be scaled back this year. But they can take an increasing level of comfort from having guided Wall Street to a view of future monetary policy that is closer to their own, and the sense that a messy adjustment now is much less harmful than a more violent turn later.

In late May, Bernanke told Congress a decision to scale back the Fed’s $85 billion per month stimulus could be taken at one of its “next few meetings”. He made the Fed’s intentions even clearer on June 19, when he spoke openly of the reduction and eventual end of the programme, potentially by mid-2014.

The result was that a yield of 1.62% on the benchmark 10-year Treasury note in early May turned into a 2.75% yield by the beginning of last week, the swiftest rise in yields in a decade, though the market has since stabilised and the yield was back down to 2.54% late on Monday. The shock sent other bond markets tumbling, and global stock markets also plunged initially but have since recovered.

Indeed, US stocks are back around record levels, restoring more than $1 trillion in market capitalisation to the S&P 500 index as investors take the view that the equity market will be able to rally through a reduction in bond buying.

“If I had to guess, I’d guess that members of the Fed are much happier with market levels than they were three weeks ago,” said Carl Tannenbaum, chief economist at Northern Trust in Chicago, noting signs that some heavy market bets have eased.

Fed officials did not welcome the steep back-up in bond yields and mortgage rates that Bernanke’s remarks caused, judging from the consternation evident in their comments since then to push back expectations of an early Fed rate hike. That has stoked suspicions that what policymakers were really worried about was a hidden build-up in risk-taking in bond markets that could have been the early signs of a bubble.

“There may have been some concern at the Fed that there was too much risk being taken on,” said Scott Brown, chief economist at Raymond James in St Petersburg, Florida. “They have certainly taken care of that situation.”

In the past, monetary policy that has encouraged too much

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