Last week’s market reaction to Fed Chairman Bernanke’s suggestion that the FOMC might begin to taper back QE “within a few meetings” represented a trial run for what might happen when central bankers really do remove the punch bowl at some point in the future. The largest reaction came in the most leveraged markets (notably the Nikkei, which fell by 6.5 per cent), but there were simultaneous across-the-board declines in global bonds and equities.
When the Fed ended QE1 and QE2, there were declines in the S&P 500 index of 15 per cent and 23 per cent respectively. These events, however, proved to be only minor fluctuations in the great bull market, which quickly resumed when the central banks announced new asset purchases.
Many analysts  believe that QE has caused a major bubble to appear in asset prices, the full extent of which will be unveiled only when the central banks start to shrink their balance sheets. Others reply that the rise in both bond and equity prices has been justified by economic fundamentals.
This is probably the most important debate in the financial markets today, with enormous ramifications for both policy makers and investors. Bubbles are notoriously difficult to identify in real time, and it is wise not to be too dogmatic about this. However, I would like to comment on three elements of the debate. Read more