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Right after trainee fixed-income traders have grasped the difference between price and yield, they learn the golden rule of the bond market: don’t fight the Fed. But for the past month, markets have been shadow boxing as they try to figure out what the US Federal Reserve wants. On Wednesday, they should get some clarity.
In May, Ben Bernanke, Fed chairman, raised the prospect of “tapering” its $85bn-a-month bond purchases. Investors reacted by dumping bonds and driving up yields as they priced in much higher odds of interest-rate rises next year. Based on futures prices, the probability of at least one rise by the end of 2014 rose from under 15 per cent at the start of May to almost evens. The knock-on effects hit overpriced assets, from junk bonds to defensive shares, while pushing up the dollar.
Two weeks ago, investors reversed their view. The odds on a rate hike dropped back to about one in three, while the dollar gave back all its gains.
But bond yields have stayed close to 2.2 per cent, up from last month’s low of 1.6 per cent. Markets are starting to expect a more nuanced message: there could be less in the way of bond purchases while rates stay on the floor out to 2015 – the date priced in before tapering was discussed.
It will be hard for the Fed to deliver this story. Investors may choose to focus on the Fed’s reduced support, as they have long cared about the level of new purchases (the Fed thinks its outstanding stock of bonds is the relevant measure). Any sudden surge in rates would damage economic recovery and risk seriously hurting share prices.
However, even if Fed messaging succeeds, markets may face a consolidation phase, rather than another chance to rally. Mr Bernanke has been clear that the taper can be increased, as well as reduced, which means economic data will be scrutinised even more than usual. Unlike a normal tightening cycle, this one could go either way. The implication is more volatility as investors react to each release.
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