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How the Fed turned a potential market route into a rally - and lessons implied for the future

The following is a partial summary of the conclusions from the fxempire.com weekly analysts' meeting in which we share thoughts about what's driving major global asset markets. The Fed's scored a huge victory transforming the taper from a catalyst for a selloff into a cause of a major rally that could set the tone for the rest of the year as we head into a light year end calendar.

The Fed scored a victory Wednesday with its beginning the taper of its QE program. Not only did it manage to avoid causing a market selloff, it caused virtually all major indexes to rally on the news.

How did they do it? As noted in our summary of last week's market action here:

By making the taper extremely minimal, clearly communicating that rates would remain low, and that future pace would likely be very gradual and remain dependent on data.

1. Because the Fed made it clear that the start of the taper did NOT herald any material change in its dovish policy:

a. The actual cut in treasury and mortgage bond purchases was only $10 bln from its current $85 bln

b. It's maintaining its commitment to keeping short-term rates low after its bond-buying program ends, even long after the unemployment rate falls under 6.5%, until inflation threatens to move over the Fed's 2% threshold and the economy and the recovery is strong enough to handle any tightening.

2. The fed also upgraded its outlook for the US economy, reducing its forecast for rates of inflation and unemployment, while increasing it for GDP.

In sum, the fed gave the markets everything they could realistically have hoped for - dovish policy AND improving economy:

• Continued dovish policy and support for the economy (and hence risk assets) until the economy can clearly handle it

• An upgraded outlook for the US economy

In sum, the fed gave the markets everything they could realistically have hoped for - dovish policy AND a bullish outlook for the US economy:

· Continued dovish policy and support for the economy (and hence risk assets) until the economy can clearly handle it

· An upgraded outlook for the US economy

In other words, the Fed successfully calmed market fears about the end of QE while still managing to being its curtailment.

Considering the historical context of the past 6 months, this was no small feat.

Since Bernanke first hinted at a coming tapering of its bond buying program aka QE, mere rumors of tapering have caused market selloffs worldwide in most risk assets. That's because most believe that the current 18 month + rally has been due to, and is dependent on, continued QE.

The belief was, and remains, understandable. Risk asset prices keep rising, stock indexes keep hitting all time or multi-year highs, yet the economic recovery in the US and worldwide has been slow and weak at best (and non-existent in most of Europe and the emerging market economies).

The belief that QE was the rally driver has been so strong that markets have commonly sold off on good economic news, and rallied on weak data, because good news implied the feared taper was coming closer, whereas bad news pushed it off into the future. Normal fundamentals were ignored as markets believed the rally would crash without sustained QE.

So the start of the taper has been a resounding success.

However this is only the start. Dangers that remain include:

· Markets have yet to price in future tapers, while it could be argued that the current one was already priced in, so continued good news or other hints of continued, even accelerated taper, could still pressure markets.

· The day of reckoning, when QE is mostly finished, and bond yields as well as benchmark interbank lending interest raise rates rise, could yet cause markets could still sell off, especially if the recovery has not continued and strengthened to the point where markets are confident that the US economy can handle it. Much depends on whether the Fed can continue to succeed at moving slowly AND on whether the US economy can continue growing enough to allow further tapering and bond yield increases.

· Looking beyond the US, {??research effect of taper on EMs), economies worldwide are at risk from Fed missteps.

· Emerging market currencies and bonds have suffered from taper fear because the threat of rising US rates, yields, and investment returns undercuts demand for their bonds and stocks unless these drop in value in order to maintain their yield advantage. Thus far the EM economies and markets have followed the US and Europe by rallying on relief that the taper did not bring any real tightening for the foreseeable future.

· In the EU, Japan, and other nations where the central banks are attempting to increase inflation and keep monetary policy loose. Those efforts could be undone if we see rising US rates, as these could pressure rates higher worldwide. This is a particular concern for the ECB and BoJ, and any other central banks looking to ease further. As long as the US maintains its dovish policy, they have time. However the clock may well have begun to wind down on US low rates if its economy continues to improve.

In sum, the top 12 lessons we learned Wednesday were:

1. The Taper was only symbolic - $10 bln, split between Treasuries and mortgage bond

2. Expect the Fed to stick to gradual moves unless it growth picks up enough to inspire so much optimism that it feels it can pick up the pace without scaring markets

3. Also expect it to continue emphasizing that it can slow, stop, or if need be reverse course, depending on the need, based on economic data. That should minimize interest rates rising in anticipation of assumed further tapers, especially if economy shows weakness.

4. The Fed changed its forward guidance - Low rates to continue long after unemployment rate drops below 6.5%" (as long as inflation doesn't rise much beyond the Fed's 2% threshold, and even then, only if the economy looks strong enough to handle higher rates)

5. Bernanke emphasizes accommodative stance, stresses that purchases will continue at rapid rate even after taper (there are other bond buying programs besides QE)

6. Bernanke anticipates the FOMC will taper QE by $10 bln at each meeting, ending sometime in late 2014 assuming the economy keeps improving and no deflation threat

7. Fed says any further tapering to continue to be data dependent, so it leaves itself the option to continue if needed

8. The decision was NOT unanimous - Rosengren voted to keep asset purchases unchanged

9. Most Fed officials don't see any rate hike until some point in 2015

10. Low inflation is a concern, the Fed now sees PCE at 1.4%-1.6% in 2014

11. Fed upgrades economic outlook even as it maintains loose monetary policy: ups GDP forecasts, sees faster decrease in jobless rate, forecasts it falling to 6.3%-6.6% before 2015.

12. Even Janet Yellen voted to taper

In sum the Fed turned the taper from a potential market route into a rally catalyst by

Giving markets enough time to price it in

· Keeping it gradual

· Providing enough forward dovish forward guidance talk to ease fears of tightening, which were the real fear of the taper

· Emphasizing that the pace of the end of QE and other accommodative policy can be adjusted as needed to minimize risk of economic (and market) damage. He let markets know he was considering their concerns.

· Stressing that low inflation is a concern, and thus giving markets another reason to believe that real tightening is not on the horizon.

Another Lesson: USD To Remain Under Pressure

Continued dovish policy means the USD remains under pressure barring a disaster in the EU (which just became a much more likely at some point, see here for details).

That suggests the USD continues its long term downtrend against most currencies and hard assets, as we discuss in depth here. There are simple, low risk easy ways to protect yourself from further damage to your USD based portfolio, and even profit from USD weakness, even while earning steady income.

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Disclosure/disclaimer: No positions. The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.

Source: How The Fed Turned Taper Selloff Into A Rally: The Real Reasons And Lessons