September 19, 2013 11:59 pm

Fed sets guessing game for traders on bond purchase tapering

Market trader watching a monitor showing Ben Bernanke©Getty

Man who moves the markets: US Federal Reserve chairman Ben Bernanke’s comments on possible tapering of bond purchases have put risk higher on investors’ agendas

On Thursday, September 5, the yield on the benchmark US government 10-year bond touched 3 per cent for the first time since 2011. The following day, the Bureau of Labor Statistics released the non-farm payrolls report for August. The yield immediately shed 10 basis points, then recovered four.

It was the same in the stock market. Stock futures initially rallied, because investors figured that a weaker-than-expected jobs report would reduce the chance of monetary stimulus being withdrawn early. Then there was a reappraisal. The data were poor, but not poor enough to force a rethink on stimulus. Stocks fell.

Nor is the trend confined to US markets. The release of marginally better-than-expected UK employment data on September 11 prompted a surge in the pound. Such wild gyrations around the release of key economic data have become a regular feature of markets lately, because the biggest questions traders face surround the timing and pace of any reduction in the amount of monetary support given to the financial system, especially in the US.

Since September 2012, the Federal Reserve has been buying $85bn worth of Treasuries and mortgage bonds each month. The chairman of the Fed, Ben Bernanke, has said it will continue to do this until such time as there is a sustained improvement in the unemployment rate.

However, in May this year, he signalled that the process of scaling back those purchases might commence as soon as the autumn. Markets have been obsessed with the so-called “taper” ever since. It was the main factor behind the sharp correction in emerging market stocks and currencies in June, and the steepening of yield curves in the US and elsewhere; UK government bond yields have also flirted with the 3 per cent mark, having hit a record low of 1.41 per cent last August.

How should traders manage risk when a rogue set of data can snap a previous trend so quickly? “Very carefully,” is the short answer, says Michael Hewson, senior market analyst at CMC Markets. “You need to look in advance at where the key levels are. You know that with something like the non-farm payrolls, you’re going to get a dollar move, so you need to draw up a plan beforehand for what you’re going to do if the numbers are good, bad or neutral.”

David Jones, chief market strategist with IG Index, says it is generally wise to wait 30 minutes or so for the market to digest the data. “Second guessing the number ahead of time is no better than flipping a coin,” he says. Trading immediately after a release is often tricky, too. “You wouldn’t have been able to get in following those UK employment numbers [on September 11], for instance, because the market gapped higher,” he observed.

Simon Smith, head of research at FxPro, agrees. “Quite often with data, you see the market move and then reverse,” he says. “Sterling reversed 50 per cent of its initial move on that labour market data. You see a similar pattern on euro/dollar around the US jobs report. On two-thirds of the occasions over the past year, we’ve seen the initial dollar reaction either partly or fully reversed within the first hour.”

Another strategy is to use options. “A straddle – buying both a call and a put option – will give you some protection whatever the market does. A straddle on the Dow would cost the equivalent of around 80 points on the index, so any movement in excess of that in either direction would result in a profit,” says Mr Jones.

However, volatility in options pricing tends to mean that the cost of such insurance rises around the dates of key data releases.

Traders might also want to consider seeking out asset classes that are less influenced by the nuances of economic data or the pronouncements of central bankers. However, this is easier said than done. “The industrial metals complex is very susceptible to data coming out of China,” notes Mr Hewson at CMC, while precious metals often move inversely to the dollar, which is very sensitive to central bank chatter. Emerging market equities and currencies have also proved sensitive to anything Fed-related – and to Chinese data.

The energy complex is less prone to central bank utterances, but comes with another set of risks. The escalation of tensions over Syria has served as a reminder that crude oil prices in particular are heavily influenced by geopolitical issues.

Mr Smith, at FxPro, suggests seeking out currency pairs that do not involve the US dollar, although he cautions that there will be a price to pay in terms of reduced liquidity and wider spreads. “Short Aussie, long Kiwi was a great trade between April and July, while sterling-yen is getting interesting, having recently broken above May’s high.”

Concentrating on specific stocks is another strategy; Mr Hewson notes that a popular trade among CMC clients is to go long of an individual stock – Vodafone and Apple are particular favourites – and short of the corresponding index, such as the FTSE 100 or S&P 500, as a hedge. Such “pairs trades” are also a feature of client activity at IG. The objective is to capture any upside in an individual share, but guard against the possibility that the wider market will lurch lower.

Short positions in stock indices may be more than just the other half of a pairs trade, though. Risk aversion is growing, perhaps reflecting the sheer number of potential banana skins that litter the trading landscape. Aside from the obvious meetings of the Fed’s rate-setting committee (on October 30 and December 18, the latter one including a press conference), there is the appointment – possibly imminent – of the next Fed chairman and the German federal elections on September 22.

Mr Hewson also points out that the German constitutional court has yet to issue a final ruling on the legality of the European Stability Mechanism; there could be further wrangling over the progress, or lack of it, in restructuring Greece’s debt; and the political situation in Italy, where Silvio Berlusconi faces ejection from parliament, remains fragile.

“I’m basically quite optimistic for the rest of the year, barring any accidents, but I’m certainly not expecting fresh record highs on the FTSE,” says Mr Hewson. “I think it’s optimistic in the extreme to be looking at 7,000 plus by the end of the year, as some are doing.” He notes that for all the talk of tapering, US jobs growth has been weaker this year than it was last.

Mr Jones predicts the intense Fed-watching will continue. “It’s all about the taper. I don’t think it’ll be a big surprise when they start to rein it in. But we might get a pleasant surprise. Perhaps people have been too pessimistic about the effect it will have.”

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