In the context of a $15 trillion US economy, you’d think that the Federal Reserve’s decision not to reduce its monthly purchases of bonds by $10-15 billion might not be a big deal.
On a long-term view you’d be right. But in the short-term, markets are subjective, and the initial reactions were potent, and predictable. Bonds and gold rallied strongly, the dollar fell sharply, and stocks rose still further; emerging bonds, stocks and currencies made the biggest gains.
Along with the market, we were surprised by the Fed’s decision. It had allowed a firm consensus on tapering to take root, and chairman Bernanke knows how important the management of expectations can be. But central banking and clarity are not always synonymous – and some argue anyway that central bank authority is best served by a certain mystique.
The issue now is whether these reactions herald more meaningful moves that should be reflected in portfolios, or whether – as we suspect – some will prove short-lived.
The Fed has held back because it wants to be confident that the US economy can stand on its own two feet.
We think it can, but – as we warned in June – as bond yields have risen ahead of tapering, pundits have argued that those higher yields will quickly derail the recovery.
And while business surveys have been robust, there is enough uncertainty – particularly around the housing data – for the Fed’s hesitation to be understandable.
We think the US economy is capable of self-sustaining, job-creating growth, even as monetary conditions slowly normalise. We see the economy itself as effectively driving the normalisation, and see the process as a healthy one.
At some stage the gap between the real risk-adjusted return on shareholders’ funds and the cost of borrowing to governments has to narrow, and the Fed has probably just postponed the formalities – most likely to December – not cancelled the event.
Our recent comments about central banks’ “forward guidance” on short-term interest rates also still apply: expectations of higher rates in late 2014 have faded, but in the last resort it will be the economy that holds the key to timing, not the Fed – or the Bank of England, or European Central Bank.
As I write, the bond and gold rallies have paused. In the weeks ahead, any soft economic data will be seized on as evidence that the Fed knows something (bad) about the economy that we don’t, and the rallies could resume.
On a three-six month view, however, we continue to prefer stocks to bonds – and maintain our preference for developed over emerging markets, although that is a closer call than it was – and had become so even before tapering was postponed.
:: Andrew Miller is a director of Barclays Wealth and Investment Management in Newcastle.