Throughout recent months, gyrations in debt markets have been considerably driven by expectations that relate to the plan of the US Federal Reserve to cut back its bond purchases – so-called tapering.

When tapering was originally mentioned in May and June, fixed income markets across the board were impacted negatively. Notably, US government bonds sold off with the 10-year benchmark yield (which has considerable implications for all markets) surging from around 1.60 per cent in May to a two-year high of 3 per cent in early September.

On September 18, the Fed announced that it would not be starting tapering, due to its lack of conviction regarding the extent of the country’s economic recovery. This triggered a rally in US government bonds (US 10-year yield currently around 2.75 per cent) and in credit markets. Investor risk appetite reignited.

Recent comments by Fed officials illustrate their discomfort with the apparent sensitivity of investor sentiment to this policy development. In a speech in Washington last week, Bernanke, the outgoing Chairman of the Fed, said that the market reaction over the summer “was neither welcome nor warranted”.

It is relevant to keep in mind that the spike in yields in the markets is precisely contrary to what the Fed has been trying to achieve through its accommodative monetary stance. This suggests that the major challenge of US authorities in the coming months will be to administer a “smooth” decrease in (and eventually termination of) the $85 billion per month bond-buying programme.

In this respect, effective communication by Fed officials is viewed as vital. Minutes from the October Federal Open Market Committee (FOMC) reveal that a number of measures are being considered to enhance this process. These include a calendar-based approach or adopting different levels for Treasury and mortgage-backed securities.

In continuity, Yellen (the nominee to replace Bernanke as Fed Chairman), noted last week that the Fed needs to communicate effectively to “diminish any unnecessary volatility”.

One particular aspect relates to movements in the federal fund rate. Since 2008 US monetary policy has been focused on injecting liquidity by purchasing securities in addition to keeping official interest rates at an all-time low of 0%-0.25%. The extent of the link (if any) between these two policy tools is a major consideration.

The Fed needs to clearly convince investors that it will not be raising rates any time soon

Basically, investors could be concerned that the scaling down of the former implies a reversal in the latter. In turn, to help avoid any market disruptions from tapering it seems that the Fed needs to clearly convince investors that it will not be raising rates any time soon.

The Fed is in fact already trying to counter any perception that the end of the bond-buying programme will be accompanied by interest rate increases. It is generally agreed that the Fed will begin to scale back purchases, with FOMC minutes referring to “trimming the pace of purchases in coming months”.

This activity has expanded the balance sheet of the central bank to $4 trillion. It could be conducive to the development of asset bubbles, and the marginal benefit to the real economy from continuing this programme indefinitely is likely to be decreasing. On the other hand, the central bank does intend maintaining interest rates at record lows due to the relatively subdued nature, particularly in terms of job creation, of the economic recovery. Additionally, US inflation remains persistently below the Fed’s target of 2 per cent.

Even if it is assumed that the Fed will hold rates at current levels and that it will do its utmost to reassure the markets, the potential impact of tapering remains a major challenge over the coming months for the global economy and for financial markets.

In its report published last month (Global Financial Stability Report, October 2013), the International Monetary Fund notes that the potential for interest rates to overshoot and cause a reduction in structural liquidity is a “key risk”.

Some investors fear a repeat of last summer’s turmoil . For years, financial markets have been swamped by abundant liquidity. The reversal of this backdrop could pose a risk to investment prospects and global economy.

This article is the objective and independent opinion of the author. The information contained in the article is based on public information.

Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.

Karl Falzon is a credit analyst at Curmi and Partners Ltd.

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