Fed tapering and the unstable equilibrium

Already, the link between equities and fixed income is reverting to pre-QE patterns: as the US economy improves, equities are rising, but so are bond yields. We expect the Fed’s policy withdrawal – likely to last several years – to usher in an environment of lower long-only returns, higher volatility and the need for more active management.

With this in mind, we still see a tactical case for overweighting equity and remaining neutral to mildly underweight fixed income into the initial Fed tapering.
That said, our US economic forecast of better growth and higher inflation implies a more disruptive market environment somewhere between the tactical (3m) and strategic (12m) horizon. The drop in USD rates vols may provide an attractive way to position for negative FI asymmetries over an uncertain time horizon.

With the US short-end anchored, we do not see an early start to Fed tapering being especially disruptive for broader risk assets. Indeed, with global growth improving, we see a case to add to our preferred overweights in cyclically-sensitive EM equities and targeted, higher-yielding EM currencies (INR, BRL and MYR).

When the US short-end does become de-anchored as markets begin bringing forward Fed rate hikes, we’d expect US equity markets to be more vulnerable than most other risk assets – though this is probably a story for H2 14.

*Photo by CNNMoney.