The past 12 months have been a real rollercoaster ride for most investors; whether bond or equity investors or whether exposed to developed or emerging markets, the capital markets have been all over the place. Until the Federal Reserve pronounced the word ‘tapering’, the market’s performance during the earlier part of 2013 was an extension of 2012. Bonds, especially the lower credit quality, long-duration paper and equity were rallying almost independently of the economic state of the more important developed market economies.

More recently the Fed has announced that tapering will indeed commence in January and that this will be by $10 billion (from $85 billion to $75 billion) a month which is far less aggressive than the market was anticipating. Furthermore, the Fed went out of its way to reassure investors that interest rates will remain at the current exceptionally low levels specifically stating that it will “maintain downward pressure on longer-term interest rates”.

Following this press release the markets rallied. This market reaction was reasonably logical but somewhat surprising. Only seven months ago, when the Fed announced the idea of tapering if unemployment and inflation were seen within a defined “comfort” zone, the markets nosedived as though they were anticipating the withdrawal symptoms of reduced Quantitative Easing (QE). Rather than focusing on the fact that the Fed was considering tapering because it was seeing as an improving trend in the underlying macroeconomic fundamentals, the market chose to focus on the immediate term (less liquidity in the system) and furthermore made a number of assumptions which today seem partially incorrect – that with tapering interest rates will rise.

Well, the Fed this time round seems to have convinced the market that interest rates will remain unchanged; however, as we have noted ad nausea in the past, one must not ignore the yield curve which is ultimately a true reflection of supply and demand. After all, if the Fed reduces its asset purchases, who will make up the difference? Chances are the Fed will keep issuing debt so is going to buy the bonds the Fed is not buying? Economics tells us that if demand for a good falls while the supply remains constant, then the price must fall to clear the market. In the bond market, a decline in price translates into higher yields. And this is where the risk lies: if yields rise too quickly then the US could see its economic recovery being choked off. There are obviously other factors at play which the market needs to keep on its radar but GDP growth is the first most important data point.

Up to now, QE has been a godsend for equity investors but the low lying fruit is now gone. The economy needs to stand on its own two feet in order to maintain and, indeed, increase the belief that an economic recovery is truly in place. 2014 is going to be the year which will either make or break the next decade in terms of both economic and capital market performance.

Janet Yellen will be replacing the current Fed Chairman Ben Bernanke when his term expires on January 31, 2014 making her the most powerful woman in the financial world. She will be taking over shortly after the all-important tapering announcement made only a couple of weeks ago and is heading the Fed during a very delicate and crucial point in time. This is the point where the US economy will be tested to see whether the 2008 crisis is truly behind us. The prognosis is bleak and the market has a way of testing new Fed chiefs.

When Paul Volcker arrived in 1979, the Iranian Revolution sent energy prices soaring; Volcker jacked up interest rates into the high double digits, igniting a deep recession to save the dollar. Alan Greenspan took the lead in August 1987. Two months later, the Black Friday market crash wiped 23 per cent off the Dow Jones index. Ben Bernanke was the next Fed chief. He took charge in 2006 and had a little over a year before Bear Stearns collapsed and the subprime crisis became the scariest financial disaster since the Great Depression. What will be Yellen’s test?

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 Micallef is an executive director at Curmi and Partners Ltd.

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