Foreword

All of the insights put forward in this article are a continuation from Trade View’s previous article; “Will The Fed Pull The Rug Out From Under The Markets?” You can read that article by clicking here. While that article took a macro or world based view of the markets in a “what if” scenario, this article aims to provide a more micro-specific view of where we should be heading now.

Introduction

Globally, the word ‘tapering’ has received a considerable amount of attention by the financial media over the past few months. The anticipation of such tapering even managed to shake the financial markets several times in the second half of 2013.

Naturally, traders and portfolio managers wanted to be ahead of the masses and in doing so adjusted their holdings in anticipation of what was believed to be the end of the world’s greatest ever stimulative package called Quantitative Easing.

Late last year the US Fed finally announced that they were going to reduce their stimulative package. However, the reduction amount was far less than what the markets had expected. This somehow restored confidence back in the markets and helped stock indices to remain strong and push higher.

But what would happen if the US Fed decided to do what many analysts call the “right thing” and considerably or even completely reduces the amount of (financial) assistance provided? Many are expecting to get a firmer guidance on such an important issue in the near future.

At Trade View we have taken some time to research the possible effects on the markets and we have outlined some of our thoughts below.

But before we begin we would like to give you a quick overview of why we are here now.

Background

In late Nov 2008 and in reaction to the global financial crises, the US Federal Reserve started a so called “Quantitative Easing (QE)” program in which it provided capital to the markets.

The aim was to restore confidence back to a hyper stressed market at that time. Since then, the Fed has introduced a further QE2 and QE3. The amount of capital provided to the markets was different in each of the 3 rounds of QEs.

In QE 3 and Since Dec 2012 till late 2013, the Fed has been buying 80 billion dollars of financial papers (bonds, MBS) on a monthly basis.

When Fed buys a financial security from the market, it essentially needs to print money (electronic money in this case) to do the transaction. That’s why you can think of the whole QE program to be a huge money printing mechanism that makes capital available to the markets at an extremely cheap rate.

When tapering does start, the Fed will be reducing/abolishing the amount of its monthly purchases and therefore the amount of cash provided to the markets will be reduced/disappear. Keeping the above in mind, let’s have a look at possible market reactions:

Equities

As explained in the above, in the case of a full blown tapering the amount of cash provided to the markets will drop significantly. This could then act as a catalyst to push the already expensive equities down as there will be less money available to be invested in the share markets.

Given there is a high correlation between the US and the developed or developing markets, other markets (including Australia) could experience the same negative impact but in a different magnitude. Countries like Australia who have for some time been lagging the rest of the world will possibly be impacted harder than a country like UK where the economy has been performing very well in 2013.

This can create pairs trading opportunities for traders trading indices. (I.e. long FTSE100 and short S&P 500.)

Ceasing to provide cash to the markets will inherently increase the cost of capital (i.e. interest rates) which will subsequently put stocks with both high valuations and high net debts under extra pressure. In the Australian market watch for the likes of Duet Group, Sydney Airport, Oil Search Limited and Transurban Group in the case of tapering occurring.

Second in our watchlist are the mining and commodity stocks. As we will outline throughout the rest of this article; we believe that the broad commodity prices will come under pressure when tapering begins. This is obviously not favourable for many mining and commodity producing companies.

Tapering may also cause the smart money to flee to Europe. This is because the Euro region is still looking to stimulate the economy by keeping interest rates low and buying bonds similar to the QE program in US. Some of the developed European countries like Germany and Austria have already started outperforming the US equity market.

The chart below shows the relative performance of Germany (red line) and Austria (blue line) against US S&P500 since July 2013. Notice how these two markets have been generally performing better than US in the past 6 months and how this out-performance has recently gathered more momentum.

Forex

When the Fed stops providing capital it essentially will be putting an end to the money printing process. Less supply of US dollars naturally equates to a stronger dollar across the board. But again, similar to equities, the dollar will not appreciate equally against all currencies. Expect a much bigger appreciation against the Euro, and the Australian dollar and a lesser increase against GBP. The reason being, that the Euro area and Australia are in expansive cycles where governments are still trying to stimulate their economies.

Another example of a country that is in a stimulative cycle is Japan, where its central bank has been buying more financial assets to support the economy. However, we are concerned that the Yen is almost already cheap against USD and more promising opportunities may be lying elsewhere. But this could still be a good trade.

Commodities

General economic theory says that an appreciation in the USD will cause the price of commodities to drop. This is because commodities are mainly valued against the dollar. Therefore a stronger dollar should automatically push commodity prices lower.

This relationship can clearly be seen in the chart below which simultaneously shows the USD Index and the CRB Commodities Index since 2011. Notice how the positive trend in the USD Index (blue line) has mirrored negative trends for the CRB Commodities Index (red line), and vice versa.

Gold is believed to be one of the commodities which will be hit hard in the case of a tapering. However we would like to draw the attention of our readers to the fact that other than USD, other factors like market stress, inflation expectation and trader’s sentiment play major roles in determining the price of the gold. Add to this current excessive bearish sentiment and oversold conditions on Gold. So we would be looking at this one very carefully.

Silver on the other hand has a different perspective. It‘s been performing quite well against other commodities in the past few months. Silver has many industrial applications and as developed economies (i.e. USA) are gradually becoming firmer, it will be more in demand. A good way to take advantage of its existing momentum is to possibly go long silver and short gold to hedge. Obviously it has to be timed well and the position sized properly.

Bonds

As stated earlier, when the Fed decides to stop providing capital to the markets, the cost of capital (interest rates) will go up. This means bond prices will have to go down to be able to be attractive under the new market conditions. Remember, bonds and interest rates have an inverse relationship. Whenever there is a conception that interest rates (or inflation) will have to go up, bond prices will drop to accommodate new interest rate expectations.

It’s important to note that bonds with different maturity will behave differently to interest rate expectations. Generally longer term maturity ones (i.e 10 year Treasury Bonds) will drop harder than the short maturity ones (i.e. Five Year Notes). So a smart way of dealing with tapering can be to go long the short term maturity bonds and go short the longer term ones.

To better understand this concept, take a look at the chart below. The red line shows the 5 Year Note price performance since the start of 2013 and the blue line is for the 10 Year Note. Since the realisation that tapering was a real possibility, the 10 year notes have dropped by over 6 percent whereas the 5 year one has only dropped by 3.5 percent.

Conclusion

Please consider “buy the rumor sell the fact “principal in dealing with tapering. Some of the above scenarios have already started to play out but have stalled given that the market is waiting for more information on this issue.

Another aspect in trading that is often misunderstood is that the markets will act rationally. However, it is important to be aware that this is not the case all the time. The recent market behaviour is testament to irrational decisions resulting in rational behaviour.

At Trade View we will be looking for keywords like “yields,” ”inflation,” and “earnings growth,” and we believe that traders should do the same to better time their trading strategies.

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