What is the Taper and Why Does it Matter to the US Dollar?

‘Taper’ fears are an issue that traders think about every single day having recently spooked world markets while stirring extreme volatility in FX, equities and bonds. ‘Tapering’ refers to the timeline for the Fed’s eventual reduction in its massive, stimulus program. The current iteration of Federal Reserve quantitative easing (QE3) accounts for purchases amounting to $85 billion in Treasuries and Mortgage Backed Securities (MBS) per month. The aim of this dedicated buying is to lower interest rates and thereby bolster growth – however investors have grown just as dependent on the unintentional side effects: rising capital markets.

Taper(noun): point at which the Federal Reserve reduces its $85 Billion monthly purchases of Treasuries and MBS. Considered a crucial first step before the support ends and is eventually reversed

Having ushered capital markets in the US to a four-year recovery, investors are closely monitoring the time frame for when the external support will be withdrawn. Though a tapering would still mean further support – just on a modestly smaller scale – speculators are conscious of the heights that the markets have been push to and the assumptions made about the future with a backstop in place.

Reflecting on the sensitivity to speculation, last week a simple statement by Fed Chairman Ben Bernanke that the Fed may taper QE “in the next few meetings” resulted in extreme volatility and a sharp drop for the S&P 500 as well as US Treasuries. And this is not a lone voter. In the minutes from the central bank’s last meeting, it was clear that the need to taper was seen by most while ‘some’ on the board were even calling for a near-term moderation.

For the US dollar, there are two elements that should be considered when it comes to speculation surrounding the taper. On the one hand, stimulus growth directly increases the supply of dollars in the system (increases inflation) and thereby its end removes a burden from the currency’s shoulder. Perhaps far more influential, however, is the impact that such a shift can have on risk appetite. If optimism has founded a significant share of its strength on the belief of indefinite support by the Federal Reserve, a reversion to traditional valuations (growth, rates of return, liquidity, etc) could find the markets abandoning richly priced assets.

— Written by: John Kicklighter, Chief Strategist for DailyFX.com

Written by: Gregory Marks

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What is the Taper and Why Does it Matter to the US Dollar?