All eyes on Bernanke: Will the markets be happy with the US Federal Reserve chairman's tapering measures? Photo: Bloomberg
It's a word that's been setting financial markets on edge since it was first raised by the US Federal Reserve in May.
The start of "taper" - a trimming of the central bank's $US85-billion-a-month ($91-billion-a-month) stimulus program, which has seen trillions of dollars pumped into the US economy since last September - was expected to commence in September but has been delayed by the Fed.
The word signals the beginning of the end of quantitative easing - a move by some central banks to counter the devastating impact of the global financial crisis.
Quantitative easing: How much will the US Federal Reserve taper its stimulus program by? Photo: Bloomberg
But what has the stimulus program been about? What is quantitative easing? What is tapering? And how will it impact the Australian dollar and the local share market?
What is the stimulus program?
The Federal Reserve - the central bank responsible for printing the US currency - launched its third round of quantitative easing (QE3) in September last year.
Unemployment target rates: Will the US Federal Reserve adjust its target rates as unemployment falls? Photo: AP
The open-ended QE3 program involved buying $US40 billion in Treasury notes (US government bonds) and $US45 billion in mortgage-backed securities every month. Since the start of QE in late 2008, the Fed's balance sheet has hit a record level of more than $US3.5 trillion as of August.
Analysts said the unprecedented size of QE means the impact of its wind back - and end - would be unclear. Read more on the Fed's QE3 announcement last year.
So how does quantitative easing (QE) work?
US housing demand: Will it continue to improve, signalling a recovering US economy and opening the door for further tapering? Photo: AP
QE has been described as the printing of money. But is it really that? What the Fed does is purchase long-term Treasuries and mortgage-backed securities.
By buying them, and thus taking them out of market circulation, they become scarcer, raising their prices and thus lowering their yields (bond prices and yields move in opposite directions).
The lower yields on long-term bonds are meant to stimulate the housing market and make other investments more attractive.
On the rise: Ten-year US government bond yields have risen amid taper speculation. Photo: Bloomberg
Through the bond purchases, "cheap money" enters financial markets. This money - because it is so "easy" to come by - is used by investors to take a punt on riskier and/or higher-yield assets, such as the Australian dollar and emerging market stocks. As such, the price of equities have also been boosted by QE.
But some critics have said the massive influx of "cheap money" has just been a manipulation of financial markets by the Fed, and the artificial boost - when removed - could see markets and economies rediscover their financial crisis woes.
Deciphering 'Fedspeak': what is tapering?
Heading north: Ten-year Commonwealth Government Securities have risen along with US Treasuries amid taper expectations. Photo: Bloomberg
Tapering, as noted above, has been used to describe a cut back of the Fed's stimulus program. There is speculation that when the Fed tapers, it is like to reduction the amount of money used to buy Treasuries, with the stimulus for mortgage-backed security purchases remaining untouched initially so the housing market recovery is not hit.
At the same time, Mr Bernanke and other Fed officials have been at pains to point out that a slowdown in stimulus does not mean a rise in short-term interest rates, which would hit economic growth. Their message is that tapering isn't a tightening of monetary policy.
Analysts are expecting the Fed to finish tapering in the first half of next year, provided the unemployment rate falls below 7 per cent.
Why taper (QE)?
The Fed believes the US economy is recovering and exiting emergency mode. But the pace of recovery is in question, with the Fed willing to wait at least one more month from September (analysts believe the next possible start of tapering is likely to be December) before its trims back the stimulus.
If the US economy continues to recover, as the Fed hopes, then it would become less and less dependent on the need for the financial boost and the central bank can slowly take its foot off the pedal.
How have financial markets responded?
Just the mention of a possible tapering by Mr Bernanke on June 20 sent the Australian dollar plunging almost three cents against the US dollar in a few seconds.
It's one clear example of the roller-coaster ride that financial markets have been on since Mr Bernanke started to signal the start of a tapering process.
It also highlights the power central bankers such as Mr Bernanke (and RBA governor Glenn Stevens, whose six-word quip about an RBA meeting sent the dollar tumbling half a cent) have on the markets. This isn't a new phenomenon. Former Fed chairman Alan Greenspan was nicknamed the Oracle for the way markets used to hang on his every word.
But aside from the immediate effects, growing expectations that tapering will commence this year has over the past few months seen investors reshuffling their portfolios and piling out of some asset classes - such as higher-yield or riskier assets such as the Australian dollar and emerging market stocks - that have been benefiting from the influx of cheap financing via the stimulus.
Emerging markets have been badly hit as funds flow back into Europe and the US. Hardest hit have been countries such as India and Indonesia, which have used foreign capital to fund their current account deficits.
Bond markets have also suffered some of their biggest monthly outflows in recent months as investors scramble to move their money elsewhere, fuelling a continued rise in long-term yields.
At the same time, the US dollar has gone from strength to strength as investors return to it and dump riskier growth assets such as the Australian dollar.
Gold has also been hit by the tapering expectations. The precious metal had been seen as a hedge against inflation by some investors, who expected inflation to rise as markets were flooded with the trillions of dollars in stimulus.
But inflation has remained low in the US despite the rise of "easy money", and gold has been sold off.
It is this tightening of financial conditions that was one of the reasons why the Fed held back from starting its tapering process in September.
Analysts say the Fed hopes that bond yields on the long-end will ease, reducing the pressure on the housing market. The rising yields had put a dampener on housing demand, another concern for the Fed.
So what should we expect after the Fed delayed its stimulus wind back? The Fed has emphasised the importance of strong and sustained economic data in influencing when tapering commences. The key indicators will be housing data and the quality of the unemployment data.
What will be the likely reaction of financial markets, including Australia's?
When the Fed does start the tapering process, it is expected to get going with a modest cut back. In September, financial markets had predicted the Fed would keep tapering to a modest level of around $US5 to $US10 billion, and amount that they had already priced in.
But if the Fed reduces the monthly stimulus by a larger amount than expected, the markets will continue their scramble out of the assets outlined above - thus possibly sending emerging markets and the Australian dollar tumbling again, while strengthening the US dollar. Other equity markets could also be pushed into the red.
Global long-term bond yields will rise, following the US's lead. "Australian bond yields will not escape that. So we'll see fixed-term lending rates be a bit more expensive than what they are at the moment," NAB senior economist Spiros Papadopoulos said.
At the same time, if the Fed is more dovish than expected and cuts by a smaller amount, financial markets are expected to rally, at least in the short-term.
What happens after that?
Much of it depends on how the Fed chooses to carry out its future stimulus reductions, and whether they will be dependent on the data coming out of the US economy - and in particular - the housing and unemployment figures.
Analysts, such as Credit Suisse's equity strategist Damien Boey, have also cautioned against too much optimism about tapering. While some optimists have argued that the start and continuation of tapering points to the health of the US economy, which - being the largest in the world - would help to strengthen other economies, Mr Boey said the market's reaction to tapering expectations have already started to stymie economic growth.
"As bond yields have risen in America, the economy has slowed very sharply," Mr Boey said, citing a slowing down in housing demand and refinancing activity.
While higher bond yields are usually seen as a sign of growth, Mr Boey said the rise in yields could be a false signal and instead be indicating an increase in risk premiums. He warns against the RBA using the higher bond yields as a sign that the economy is improving and its own easing cycle could be at an end.
Interviews with: FXCM currency strategist Ilya Spivak, NAB senior economist Spiros Papadopoulos and Credit Suisse's equity strategist Damien Boey.