Forget data and rhetoric, Fed liquidity's the only show in town

Nov 17 2013, 21:34 IST
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Investors confident that Fed won't withdraw liquidity soon (Reuters) Investors confident that Fed won't withdraw liquidity soon (Reuters)
SummaryMarket volatility down in Treasuries, stocks, dollar exchange

For all the fevered speculation about when the Federal Reserve will begin scaling back its monetary stimulus, market volatility has been taking a leisurely nap, suggesting investors see no major shocks on the horizon to derail their bets.

Low market volatility is a sign markets expect no "taper" any time soon, or that they are steeled for a reduction in the pace of the Fed's bond-buying if it comes.

The sting of the taper has been gradually sucked out of markets since the Fed's surprise decision not to start withdrawing stimulus in September.

Since then, implied volatility in U.S. Treasuries, stocks and key dollar exchange rates has sunk close to its lowest in months, or in some cases years.

This might come as a surprise, given the noise surrounding the latest relatively upbeat U.S. employment and economic growth figures and the keenly awaited congressional testimony from Fed Chair-elect Janet Yellen last Thursday.

But the Fed's $85 billion-a-month asset purchase programme trumps everything, and as long as the liquidity taps are open, the economic data will only have a real impact on markets if it changes the Fed's thinking.

"We're not trying to follow the twists and turns of the very short-term investment cycle," said Kevin Gardiner, head of global investment strategy at Barclays Wealth in London.

The same goes for data or Fed commentary, he said. Only if they "dramatically changed" the Fed's policy outlook would he consider altering his strategy.

Market pricing and indicators suggest he's not alone. Wall Street last week posted record highs on an almost daily basis, and the S&P 500 and Dow Jones Industrials have risen for six consecutive weeks.

This has been fuelled by a collapse in volatility from the unusually high levels around the U.S. debt ceiling and government shutdown crisis in early October. The VIX index of implied volatility for the S&P 500 fell to a three-month low on Thursday.

It's a similar story in the U.S. bond market. The 'Mermove' index of three-month implied volatility on Treasuries has almost halved since early September.


The following chart shows that since mid-2011, the correlation between U.S. economic surprises and two-year Treasury yields has completely broken down:

The ebb and flow of data surprises - both positive and negative - has had virtually no bearing on yields, which have remained at historic lows thanks to the trillions of dollars of liquidity and zero interest rates from the Fed.

Currency traders are even more sanguine. One-month

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