Tapering

It did not take long for the markets to react to Fed Chairman Bernanke’s communique and subsequent clarifications following the Fed Open Market Committee (FOMC) meeting. The result; two successive days in which the Dow Industrial Average, and more importantly the Canadian equity markets, fell sharply only to stage a minor recovery on Friday. Look for more of the same this week with a bias to the downside.

On the surface you could argue that the equity markets overreacted. Perhaps… although I am of the view that Wednesday’s sell-off was Fed related, while Thursdays sell off had more to do with worries about an impending credit crunch in China. More on that in a moment!

First we need to understand why the markets reacted so violently to the Fed’s statement that provided a rather cryptic time line for tapering. I suspect it had to do with an interview that President Obama had with Charlie Rose prior to the G-8 summit and which was aired last week. In that interview, President Obama made it clear that Mr. Bernanke would not be re-appointed as Fed Chairman after his term expires in January, which created an obvious time line for tapering.

Politically, it is better to saddle the incumbent Chairman with the inevitable backlash from tapering in the process sparing the newly appointed Chair from having to make major decisions during the honeymoon period.

The problem is that traders believe housing will be the first casualty of tapering. The Fed’s quantitative easing has involved significant purchases of mortgage backed securities in an attempt to keep mortgage rates low. Most believe that through the primary stages of tapering, the Fed will pull away from that market in favor of government bond purchases. That belief has already impacted mortgage rates, which some fear could stall the fragile real estate recovery.

Needless to say, this action will impact other global markets much as it did in Canada. Note last weeks’ 40 basis point increase in Canadian mortgage rates – especially on five year fixed terms – which occurred in lockstep with the Fed’s statement.

China Credit Crunch

For the past few weeks, China has been tightening credit in an attempt to curb the speculative fervor that has engulfed their real estate market. The concern is that China’s strength – i.e. the pace of its’ economic growth – may also be its Achilles heel. To wit; scale!

At the best of times, central bank intervention is more art than science. When you throw in the complexities of China’s mammoth economy, it is almost impossible to manage this transition smoothly.

China’s central planners quickly discovered that slower growth as a result of tighter credit was imploding into a wholesale credit crunch which threatened economic collapse. They responded as they so often do by throwing money at the problem. In this case more than US $1 trillion!

The question is whether or not it will work? If you think that central bank intervention is nuanced… try managing the world’s second largest capitalist economy with a political system rooted in communism.

Most likely, China will sidestep a wholesale credit collapse this time, but longer term China’s political elite will have to find a way to manage inherent capitalist excesses without stymieing growth. To do that will require a wholesale change in ideology that can balance moral suasion within a free market environment. Unfortunately, if we have learned anything from the Eurozone peripheral States, shifts in ideology can be political suicide.

Longer Term…

In time, the market will drift away from short term concerns related to the removal of liquidity and focus instead on the rationale for Mr. Bernanke’s tapering. As he suggested, the US economy was beginning to show signs of stability and dare we say it… growth!

Even slow growth will be a welcome change as it will allow investors to focus on real long term metrics like corporate earnings rather than making emotional decisions driven by excess liquidity.