17/06/2013 07:31 BST | Updated 13/08/2013 06:12 BST

Which Are the Tails and Which Are the Dogs?

The markets are suddenly very unfamiliar places, especially for those who have grown up with the risk- on/risk-off reaction functions that have dominated the last five years.

Sure, some things don't change. The value of the Yen on the foreign exchanges, for instance, still seems to be very closely tied to the relative health or otherwise of risk assets. So, as stock markets have corrected over the last few days, Eurozone peripheral bond spreads have widened, and emerging market currencies have come under pressure, the Yen has duly appreciated, and pretty dramatically to boot. I always love the old saw which says USD/Yen goes up the staircase and down the elevator shaft.

This is just about the only normally observable pattern of the last few weeks, since Bernanke dropped his bombshell comment that Quantitative Easing (QE) may be tapered 'within the next few meetings' and US economic data releases have been erring on the strong side.

Take the US Dollar for instance. Over the last few years we have seen the USD strengthen due to safe-haven flows in times of crisis, even though the Yen may strengthen even more. This time, however, even as the Yen has strengthened, the USD has also weakened against other major currencies e.g. the Euro and the Pound. This is even more surprising, as one would have thought a lot of punters would have bought Euros and Pounds against the Yen, due to Abenomics and the Bank of Japan's Damascene conversion to the joys of money-printing, and thus would now be unwinding those positions, taking the EUR/USD and GBP/USD lower in their wake. This has been a previously observed phenomenon, but not this time.

The trouble is we are sitting rather uncomfortably on a huge and very sharp inflection point for the markets. Cheap money, in the form of QE, has seeped into every market you could possibly imagine, from mainstream stocks, to corporate bonds, to commodities, to leverage loans, to currencies, to boiled sweets and of course, the biggy, government bonds. As Andrew Haldane, the Bank of England's Executive Director for Financial Stability, recently observed rather pointedly, 'we have intentionally blown the biggest government bond bubble in history'.

The end of, or even the reduction of the pace of QE (and the latter is all the Fed is so far signalling) was always going to be a challenge for the Fed, and other central bankers, potentially giving rise to truly massive market volatility, but they couldn't just leave the subject as the elephant in the room which dare not speak its name.

It's pretty obvious that there is a strong and growing view at the Fed and the Bank of England that they had better grab the nettle, as the consequences will only become more frightening the longer they wait. The Fed's cohort of hawks will also swell in January when the annual rotation brings in much more hawkish Regional Fed Presidents as voters. The nightmare everyone wants to avoid is a repeat of 1994's bond market slaughter - goodness knows what that would do to the health of banks whose balance sheets have become stuffed with government bonds, ironically partly due to more onerous liquidity regulations introduced after the credit crisis. I'm sure these central bankers would like their major banks to quietly reduce their holdings from here on in, and this might well have the welcome side effect of encouraging them to use the cash thus released to lend to real people and businesses! Thus addressing the lack of money transmission by which major developed economies are currently plagued.

Traders listened to Bernanke, watched his lips, and remembered what they learned on their mother's knee, namely, 'don't fight the Fed'. So, they bought USD in expectation of further rises in USD interest rates, especially relative to the sclerotic Eurozone and UK economies' rates. They also probably thought they were onto a real winner as, in the event that riskier assets like stocks and emerging markets crumbled because of the Fed's change of heart, then the USD would be snapped up as a safe-haven. Surely?

The only reason I can think of to explain the recently observed general USD weakness is that currency traders have started to fear that other markets, the risk asset markets, are also watching Bernanke's lips and may collapse, leading to a flight into US Treasuries, with a concomitant fall in yields, and possibly even the creation of a feedback loop which causes the Fed to continue QE ad infinitum. Hence USD weakness. See what I mean when I suggest in this piece's title that 'tails' and 'dogs' seem to have become rather horribly confused right now?

Here's what I think. Any blip lower in yields will be short-term, as the Fed knows it needs to stick to its guns and wean us off QE. A fall in risk asset markets will also be secretly welcomed by the Fed as a necessary condition to avoid the inflation of even bigger bubbles. The bond markets are now the dog, rather than the tail which is wagged by risk asset markets.

So, my guess is that USD bulls will ultimately be proved correct and make money, as yields continue to march higher - provided these traders haven't already been carted out on a stretcher, as volatility drags their positions below whatever career stop-loss level their employer cares to impose.