For some reason, we are not surprised any more from the recent price action of the market. Well, we really should. Considering the determination of the market and the lack of a decent pull back, the recent uptrend is obviously something very rare. The reason for this remarkable uptrend is said to be attributed directly to the “FED’s tapering”. What’s all about that “tapering” that everybody talks about? And why is is affecting the market in such a way? On this post we will elaborate on this important subject.
“Tapering” is a term that exploded into the financial lexicon on May 22, when U.S. Chairman Ben Bernanke stated in testimony before Congress that that Fed may taper - or reduce - the size of the bond-buying program known as quantitative easing ( ).The program, which is designed to stimulate the economy, has served the secondary purpose of supporting financial market performance in recent years.
The Basics of Quantitative Easing:
The U.S. (“the Fed”) plays an increasingly active role in the performance of the economy and financial markets through the use of its many tools. The most well-known of these tools is its ability to set short-term interest rates, which in turn influences economic trends and the yield levels for bonds of all maturities. The enacts a low-rate policy when it wants to stimulate growth, and it maintains higher rates when it wants to contain . In recent years, however, this approach ran into a problem: the Fed effectively cut rates to zero, meaning that it no longer had the ability to stimulate growth through its interest rate policy. This problem prompted the Fed to turn to the next weapon in its arsenal: quantitative easing.
What is Quantitative Easing?
The Fed, or any for that matter, enacts quantitative easing by creating money and then buying bonds or other financial assets from banks. The banks then will have more cash available to loan. Higher loan growth, in turn, should make it easier to finance projects – for example, the construction of a new office building. These projects put people to work, thereby helping the economy to grow. In addition, the Fed’s purchases help drive up the prices of bonds by reducing their supply, which causes their yields to fall. Lower yields, in turn, provide the fuel for economic expansion by lowering borrowers’ costs.
This is how the idea works on paper, at least. In practice, banks don’t have to loan excess cash. If banks are tentative and lacking in confidence – as was the case in the years following the financial crisis of 2008 – the higher money supply may not prove to be the engine of growth the Fed had in mind.
While Bernanke's surprising pronouncement led to substantial turmoil in the financial markets during the second quarter, the Fed has not yet begun to taper . The decision to adjust the program is based on incoming economic data, and the economy has not yet become strong enough for the Fed to feel confident in reducing the level of stimulus. As a result, the Fed's bond-buying program remains fully intact at a pace of $85 billion per month.
Currently, the consensus estimate is that the Fed will begin to reduce the size of its program at some point in 2014, most likely near the end of the first quarter. However, the range of potential outcomes is wide given that 1) the program is data-dependant and 2) both the Fed chairmanship the several board positions will change early next year. As a result, both the timing and extent of any tapering remains very much up in the air.
("Data dependant" means that weak growth would lead to a continuation of , improved growth and/or rising would prompt the Fed to pull back).
The act of Tapering obviously dictates the pace and direction of the market, at least for the short term. We see it on the reaction of the market when that subject is being addressed.