Taper surprise fires credit rally

The US Federal Reserve isn't in the habit of shocking the markets. Back in 1994, when it surprisingly hiked rates, the central bank triggered a major selloff in US Treasuries.

But in 2013, the Fed's unpredictability instead sparked a strong rally in credit and equities. Investors had priced in that tapering of QE would begin in September; the consensus was that the Fed would cut its purchases of securities by $10bn to $75bn a month.

However, Ben Bernanke and his fellow governors refrained from taking any action, citing tighter financial conditions and disappointing economic activity. Bernanke shouldn't have been surprised by the first effect; after all, it was his guidance on QE earlier this year that pushed Treasury yields up.

But he may have some justification on the latter point. The recovery is still slow by historic standards and Bernanke played down the unemployment threshold laid out in his earlier Federal Open Market Committee statements, suggesting that he would prefer to see the labour market in ruder health before he takes action. Concerns about possible asset price bubbles are clearly secondary to growth from the Fed's point of view.

Nonetheless, the credit markets were buoyant on the news that the Fed's largesse would continue unabated. The Markit CDX.NA.IG index rallied to 69.25bps, the tightest close since October 2007. Of course, the index constituents have changed several times since then, so it is not a direct comparison. However, it is still an indication of the positive conditions in US credit.

The Markit iTraxx Europe followed suit and tightened 4.5bps to 88.5bps. Miners and credits based in the periphery, which have benefited from the excess liquidity in the financial system, were among the biggest gainers.

But the real winners were emerging market sovereigns. They have borne the brunt of QE tapering fears, and saw their spreads widen sharply since May, when Bernanke sent his first signal. The likes of South Africa (168bps, -25), Turkey (170bps, -26) and Indonesia (200bps, -33) were targeted by investors due to their current account deficits, and outflows from emerging market funds increased sharply during the summer months.

The prospect of more liquidity from the Fed drove a sharp recovery in their spreads, though in most cases they are still considerably wider than where they were at the beginning of the year. The weak external positions of many emerging market sovereigns are likely to persist, and the Fed could reverse its dovish stance if the data turns strongly positive.

Overall, the perceived shift in the Fed's direction is positive for credit in the near-term, and we can expect supply to increase in the primary markets over the coming weeks as borrowers take advantage of the low rate window.

December now seems to be the new consensus for QE tapering, though yesterday's events reminded us that second-guessing the Fed can be a dangerous business.

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