Fed Tapering Kicked Off, But What's Next?‏

After much back and forth the Fed finally had the data on hand to start the tapering process. It is clear, though, that the Fed is not aiming for tighter financial conditions but simply a different mix, in which it takes the foot a bit off the gas on QE while stepping it up on forward guidance.A more cautious tone on inflation also helped balance the message from the Fed.

Mission accomplished and the Fed must be very happy with the reaction in the markets. Stocks rallied, bond yields were broadly unchanged while the USD strengthened somewhat. Emerging Markets have also been fairly quiet. This is in stark contrast to the experience over the summer when the Fed first signalled tapering. Back then bond yields rose sharply, stock markets sold off and Emerging Markets suffered great losses and currency weakness. On Thursday bond yields showed a slight delayed reaction as the market sold off a bit but overall the move has been moderate.

In many ways the recent market developments are a relief. As we argued last week, the markets were prepared for tapering but the positive news is really that even when the markets realised that tapering was coming, we did not see another round of turmoil. One of the big concerns in the market has been ‘what will happen when the Fed starts taking the drug away’. This concern has eased and at least for now dampens another risk factor in the market.

So where to go from here? We believe the key drivers for financial markets in the first half of 2014 will be the following.

1. Global recovery to gather steam with more engines pulling. We continue to see signs that, especially, the US and Europe are picking up speed and that growth will move up a gear in early 2014 (see below). The main factors behind the stronger outlook for 2014 are much less drag from fiscal policy, fading headwind from the bond yield spike in the US over the summer, improving sentiment and pent-up demand. We also look for general improvement in Emerging Markets outside China as exports to developed markets pick up and inflation pressures are generally moderate. Chinese growth will likely peak soon but remain decent next year as higher exports and consumption will compensate for weaker investments.

2. Inflation to stay low – but deflation is not in the cards. Falling commodity prices and large output gaps have led to a sharp decline in inflation. We believe inflation will go even lower in the euro area while it is expected to stay low in the US for some time. In the euro area the deflation scare may increase but we generally believe the fear is exaggerated.

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