On the Fed’s tapering and the volatility in Japan

Yesterday, Ben Bernanke said that the Fed would start to wind down its QE program sometime this summer as I indicated early last week I believed the timetable would be. Market pundits believe these remarks triggered a sell-off in global equities, with Japan being hardest hit as the Nikkei fell 7.3% this morning. I was more concerned about the poor Chinese PMI print. But if the pundits are right, it is an extraordinary move into risk-off thinking given that the Fed had telegraphed its intentions. This incident shows you how the Fed’s exit path is fraught with risk. Japan is another story altogether.

Early this month, I noted that the data started to break a bit to the downside and wrote my daily commentary saying that as the US economy stalls, the Fed’s timetable is getting pushed back. Since that point three weeks ago, various Fed officials have reinforced this idea, stressing that the purchasing of assets could accelerate or decline depending on the state of the economy, particularly jobs.  My overall view here is what I said early last week: “zero rates will continue for some time, with a tapering of QE beginning sometime mid-year…If the key numbers like jobless claims, unemployment and GDP come in fine between now and June (with 330k average new jobless claims, +200k on non-farm payrolls, and +2% real GDP growth), then tapering can begin in June already. If any of these numbers is weak, we could see a delay. I expect tapering sometime this year though because the Fed is concerned about asset markets. We would have to see a complete collapse in growth not to get tapering sometime this year.”

Fed Chair Ben Bernanke, in fact, said exactly this – bad data means a delay to tapering while good data means tapering this summer.

Yet, the markets in Asia started selling off and all of the media outlets are saying the Fed was the trigger. If true, this tells you that the signalling power of QE for risk-on or risk-off is very powerful – more powerful than I have believed. I don’t know how this matters for short-to-medium term positioning because the Fed will taper only if the jobs picture and economy look good, which is bullish for asset markets. It won’t taper if things look bad – and that is supposed to be also bad for asset markets. Yet, the selloff today – with S&P futures also down – tells you that the market is trading more on asset speculation than on fundamentals. If Ben Bernanke’s tapering comments are causing extreme volatility, it suggests QE is creating a risk-on speculative environment

I am more concerned about the horrible Chinese manufacturing PMI data. It sank to below 50 for the first time in seven months and was below expectations as well. The European manufacturing PMIs however were both rising and above expectations, yet still mostly below 50. On a fundamentals basis, Europe is in a recession and China is slowing so much that it may not hit its 7.5% growth target. That speaks to poor economic fundamentals in big markets outside of the US and Japan.

As for the volatility in Japan, the markets there sold off much more than anywhere else. Other Asian markets were down maybe 2%. And the Japanese government bond market was equally volatile, 10-year yields briefly vaulting to 1.0% before settling down again at 0.85%. The Japan bears see this as more signs of the beginning of the end for Japan. I see it as a long overdue correction. Two weeks ago I noted that the Nikkei 225 was up over 70% in 6 months while even the huge move in US equities in 1932 didn’t precede as fast. That said, the US market was up from a bottom of 40.56 in July 1932 to a high of 110.53 one year later. That’s almost triple. It says the Japanese market move is not completely outside of the norm. But it is on the extreme end and is very frothy. Bottom line: if the Japanese real economy improves but yields stay put, that’s still bullish for Japanese equities. But if yields rise as inflation expectations become unanchored, that’s bearish for both Japanese bonds and equities.