The Federal Reserve released their latest minutes from the FOMC meeting last night. The consensus was that the Fed will start to reduce their asset market purchases gradually when the economic data signals it is appropriate. The Fed did not provide a timetable, nor did they indicate a magnitude for the reduced purchases. What was clear, is that they do not intend to increase their asset purchases. Tapering appears to be the next change in Federal Reserve policy.
So how did the markets react to this new information? The diagram below shows the performance of the VIX from 1:30 PM to market close. The VIX is a measure of market volatility taken from option prices, where an increase in the VIX reflects higher demand for downside protection. The diagram shows that the initial reaction was to buy downside protection, indicating that investors expected markets to fall on the news. Eight minutes later, however, the market changed its opinion and the VIX began to fall significantly for the next hour or so. Towards the end of the trading session, the market changed its mind again and the VIX began to rise only to finish at the same level at which it started before the Federal Reserve announcement. ‘Risk neutrality’, it would seem, is the correct characterisation of the impact of Federal Reserve tapering.
The popular press argues that the Federal Reserve asset purchases have been fuelling demand for risky assets elsewhere, and therefore halting their purchases will lead to falling asset prices. This depends upon a critical link between the Fed’s purchase of an asset being reinvested into another asset with a higher risk profile. For instance, if the Fed buys a five-year Treasury Bond from a bank, then the bank must turn around and buy an equity, a corporate bond, some property or something with higher risk. This does not seem to have happened. The evidence suggests that the proceeds from Federal Reserve purchases have either made their way back to the Fed as bank reserve deposits or been used to deleverage investment portfolios. Far from fuelling additional risk-taking, one could argue that the Federal Reserve purchases have actually lead to less risk-taking in the financial system.
If the Fed’s asset purchases have been risk neutral or risk reducing, what will be the effect of tapering? The risk neutral case is simplest. In this scenario it should be quite easy for the Fed to find investors to switch back into asset markets with equivalent risk and there should be no impact on market prices. If the Fed purchases were risk reducing, then they need to entice switching from lower risk assets back into the Fed’s asset holdings. This means lower risk assets will be bid up relative to the Fed’s portfolio. Practically, this means that short-term interest rates might need to fall and/or credit spreads contract.
This is a far cry from what many see as the impact of tapering. For its part, the VIX seems to favour the risk neutral argument since after a few hours of indecision, the market forecast for risk wound up exactly where it started!