Tapering – What does it mean and why does it matter?

View from the dealing floor.

by Chris Tripp, IG.

‘Tapering’ is a word being used more commonly by investors in recent times; it is dividing the opinions of economists and causing global volatility. But what does it actually mean? Why is everyone watching and waiting for signs of it? And if it does happen how will it impact the global financial markets?

Since September last year the US Federal Reserve has been buying a whopping $85 billion of securities on a monthly basis, compiled of $40 billion of mortgaged-backed securities and $45 billion of Treasury-backed securities. This cash injection’s primary objective is to help stimulate the economy by bringing down long-term interest rates– a process commonly known as quantitative easing (QE). However, it has been fulfilling a secondary role of late, supporting the performance of financial markets, with any mention of its scale-back having detrimental consequences on the very same markets it is supporting.

Tapering is a phrase which saw its way into investors’ vocabulary back in May this year, by the then head of the Federal Reserve Ben Bernanke.  He stated in his testimony to congress that the Fed could ‘step down their rate of purchase’, which sent shockwaves through the markets causing the Dow to drop over 100 points. Essentially, tapering is the winding down of this security purchasing policy as the economy recovers and thus, in theory, providing a seamless transition for the economy back to self-sufficiency. 

Fast forward to September this year and it was widely perceived by analysts that this tapering would make its debut, however Mr Bernanke shocked these analysts by deciding the economy was still too fragile for tapering. As a result the Dow Jones strengthened by over 700 points in an eight day period, breaking the 15,710 level.

Investors have become obsessed with QE of late; any news surrounding a possible scale-back has sent the markets into disarray. It has even been said that Fed is currently a prisoner to the reaction that the financial markets will have to any sign of tapering.

Evidence of this is all too clear. Looking back at the most recent non-farm payroll figures, the US economy produced 204,000 new jobs, a respectable 79,000 more than expected. This is a positive sign for the US recovery, however the Dow Jones fell 85 points in the 15 minute period after this figure was release. This logic-defying move is widely thought to be because one of the criteria for tapering is a reduction in the current 7.3% US unemployment rate, meaning investors sold shares in fear that tapering could make an appearance sooner than expected.  

Janet Yellen has recently been unveiled as the successor (pending a vote) to Mr Bernanke as head of the Federal Reserve. During Ms Yellen’s first Senate hearing she confirmed her intentions to continue the current QE efforts emphasising that the Fed isn’t a prisoner to market reactions and is not creating an ‘equity bubble’. This has been accepted positively by analysts who now see QE continuing for longer than previously thought.

This caused the Dow Jones and S&P 500 to break closing level records for the third day running.

Reminding analysts that tapering is inevitable, Morgan Stanley chairman and CEO James Gorman noted, ‘Every now and then, markets behave like schoolchildren. They overreact, they run around like crazy. We know we're going to have tapering, we know we are living in an artificial state of excess liquidity right now and it's happening because the economy is recovering.’

Tapering should not be unexpected given the current pace of the US recovery, however looking at historical trends just the announcement of its introduction could initiate a wide-scale sell-off of global indices and cause the US dollar to weaken across the board.

Keep up-to-date with what happening on the financial markets here http://www.ig.com/au/market-news-and-analysis.

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