In the past year, the word "tapering" inspired moments of panic in global financial markets. Tapering refers to the U.S. Federal Reserve's gradual retreat from the Quantitative Easing ("QE") programs pursued by Fed Governor Ben Bernanke in the immediate aftermath of the Global Financial Crisis. Reduced reliance on QE is at the heart of the Fed's "return to normalcy", and, over time, seems likely to result in higher interest rates. This has serious implications not only for the U.S. treasury market, but for virtually all asset classes globally.
At the end of 2013, we learned that Janet Yellen, often portrayed as a philosophical fellow traveler of Ben Bernanke, would inherit Bernanke's post as Federal Reserve Governor. The Fed also had announced plans for modest monthly reductions in QE through 2014. Whereas earlier in the year the market was prone to wild swings on the basis of "will they or won't they" speculation about the prospects of Fed tapering, actual news that the Fed would, in fact, taper according to a pre-announced schedule received a favorable welcome from investors worldwide.
If it seems as if this note is headed toward prognostication about what the Fed will do, rest assured, you are still reading something written by Third Avenue. We are ultimately agnostic about the direction of future Fed policy, because predicting macroeconomic events is notoriously difficult and nearly impossible to get right on a consistent basis. One could reason, for example, that rising rates would force equities to sell off and lower levels of liquidity. Conversely, one could reason that investors may view Fed tapering as a sign that the Central Bank believes the worst economic conditions are behind us. Both conclusions indeed seem entirely plausible; however, if the historical track record of market prognosticators is any guide, both of these predictions should be taken with a grain of salt.
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