The long and tapering road

With the Federal Reserve tapering its quantitative easing program based on future economic data, markets can expect some unusual movements in the coming months.

With the Federal Reserve tapering its quantitative easing program based on future economic data, markets can expect some unusual movements in the coming months.

As the market continues to digest the 19 June statement from the US Federal Reserve's Federal Open Market Committee (FOMC) on tying the start of its securities purchasing draw down to a 7% unemployment rate, experts expect that such an arrangement will see the US equities markets to grow on weak economic news and decline on strong news for a long time to come.

"If some economic data misses expectations or is on the wrong side of the fence, it would be good for the equities markets since it would delay the Federal Reserve's tapering plans," explains Trent Wagner, principal at Chicago-based futures contract merchant (FCM) Futures & Options Xecution (FOX).

Since the FOMC made its announcement, US markets have already bounced back from their initial knee-jerk reaction to the news.

"The day the Federal Reserve made the announcement the market traded approximately 2.3 to 2.4 million 10-year US Treasury contracts," says Wagner. "A week later, the trading volume was back to roughly 1.4 million contracts, which is about average."

However, this particular sell-off also included US Treasury bonds and notes as well as equities. Only the US dollar market did not sell-off and acted as a safe-haven asset. 

Level heads should not have been surprised by the news since the Federal Reserve has been hinting at it for a while, according to Michael Thompson, managing director, Global Markets Intelligence at S&P Capital IQ. "But I'm not sure if they expected to see a 45 to 50 basis point reversal so quickly on the back end of their comments."

The real breakout in rates volume and volatility began in May, when the FOMC stated it will look to start its tapering plans later in the year, but did not tie them to a specific economic data metric.

The CME Group saw the year-over-year month-to-date growth in its interest rates complex's average daily volume for June 2013 was nearly 70% higher than in 2012, according to Sean Tully, managing director interest rate products at CME Group. 

For the nine months leading up to April 2013, mid-curve options on the September 2015 euro dollar future contracts traded from a low of 98.81 to a high of 99.33.

"The high on 1 May was 99.40 and a recent low was 98.59," he adds. "The trading range over the past two months is larger than the entire range for the previous 10 months. This show the massive increase in volume and volatility."

This may be one reason why so many Federal Reserve stalwarts were opining publicly that the Federal Reserve would not taper its purchases if the economic data is weak and that they might even add more accommodation to stimulate the market after the initial reaction, postulates S&P Capital IQ's Thompson. 

It is all about the trip and destination

Although the Federal Reserve stated that it plans to end its tapering policy by mid-2014, the goal is overoptimistic and expects it will take years to accomplish its goal based on the current recovery, according to Thompson. 

"It's been incredibly elongated and just as the economy starts to gain traction some hurdle like the Japanese earthquake and nuclear disaster, the commodity shock or events in the European economy pop-up and push the economy back down until it can gather its strength again," he explains. "I don't think this will change. The good news is that such events impede, not extinguish, positive growth."

It may take a decade, or even a generation, for the Federal Reserve's balance sheet to return to its pre-crisis scale, if it ever does. Thompson estimates. Slowing the process will be the asymmetrical nature of the Federal Reserve's accommodations, which it made to prop up the market.

"In an emergency the Federal Reserve put them in with a dump truck, but they will be taking them out using a teaspoon," says Thompson. 

As such, the FOMC will be tied even tighter to the economic indicator reports released every month to determine when to taper its purchases and by how much.

"The prudent thing for the Federal Reserve would be to take it slow," he adds. "If they take it slow and do not overstep themselves, the market will become comfortable with the new environment. If they miss making the right decision once or twice, but the market is comfortable, the results will not be disruptive."

This is a good thing since Thompson expects that the markets facing another strong headwind in mid-2014 as a swathe of new regulations come into effect.

"There's no way around it," he says. "Business leaders are considering this and they are being very conservative with their expenditures, yet things still continue to improve."