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

The sun rises to the east of the U.S. Federal Reserve building in Washington, July 31, 2013. REUTERS/Jonathan Ernst
The sun rises to the east of the U.S. Federal Reserve building in Washington, July 31, 2013. REUTERS/Jonathan Ernst

By Jamie McGeever

LONDON (Reuters) - 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 program 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 <.SPX> and Dow Jones Industrials <.DJI> 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 <.VIX> 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 <.MERMOVE3M> of three-month implied volatility on Treasuries has almost halved since early September.

CORRELATION BREAKDOWN

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

http://digbig.com/5bjdyf

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 implied volatility on the euro/dollar exchange rate posted its lowest daily close on Thursday since 2007.

"The foreign exchange market is digesting signs that the period of peak liquidity will remain in place for the foreseeable future," Brown Brothers Harriman said in a note on Friday.

At her nomination hearing on Capitol Hill On Thursday, Yellen said it was "imperative" that the Fed did all it could to promote a "very strong recovery".

That wouldn't have surprised anyone. But what might have raised a few eyebrows was her assertion that she wouldn't rule out using monetary policy to address asset price "misalignments", otherwise known as "bubbles".

This marked a departure from former Fed chief Alan Greenspan and current incumbent Ben Bernanke. Both said it was virtually impossible to detect bubbles in asset markets and was not the Fed's business to deal with them.

But tightening monetary policy to cool asset markets is less likely than tightening to meet the Fed's mandate on employment or inflation, which remain well short of the stated goals.

In that light, the taper, when it comes, will be a "slow, careful withdrawal of stimulus", reckons Bank of America-Merrill Lynch, forecasting another 10 percent rise in the S&P 500 over the next 12 months even as the Fed exits.

"Fear not the Fed," said the bank's U.S. economist Ethan Harris.

(Editing by Will Waterman)

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