Things had been quiet in markets, perhaps too quiet, so the burst of volatility was perhaps overdue. However, there are reasons to think that the arrival of the dreaded taper is not as close as some might fear.
On the one side of the argument, data is getting better. The trend has been in evidence for some time, and while the US Federal Reserve is technically only concerned with the US, it is not likely to ignore blithely the recent upturn in figures from the embattled eurozone. Yesterday’s figures from the US confirmed that this economy is still seeing a broad-based recovery, and today’s numbers on housing starts, building permits and the Michigan confidence index are also likely to give the impression of an economy on the mend.
Of course, we are currently in a ‘good news is bad news’ frame of mind, since investors have once again begun to think that the more good data there is, the greater the likelihood that the Fed will cut back on asset purchases in September. Thus, the week could end on a particularly weak note for markets, calling into question whether the current leg of the rally can be sustained.
However, I remain of the opinion that a Fed taper is coming later, rather than sooner. Economists might think that September will be the starting point, but I would point to the current US inflation rate, currently at 2% (and 1.6% for ‘core inflation’, which excludes food and petrol), as a sign that we are not in taper territory just yet.
The Fed has a target of 2%, but it prefers to use the personal consumption expenditure rate, and this is currently at 1.3%, while producer prices, which are often a useful leading indicator, were flat in July. Thus the central bank may still stay its hand in September. Although it has been stung by charges that it is stoking inflation, the Fed is actually more worried about deflation, where prices continue to decline, and the baleful effects this has on an economy (see Japan, 1990 - now).
Even if they start to taper, a drop back from $85 billion per month in purchases to $75 billion is still not earth-shattering. The Fed will carefully watch any reaction in markets, and will moderate their approach if they feel that one tapering move is sufficient for the moment.
We are certainly in for more volatility, and with low volumes at present times will be difficult for the quiet trend followers out there (myself included), but this should not be taken as indication that the current rally has run its course just yet.