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The Market Reaction to the Great Taper May Surprise You

Traders work on the floor of the New York Stock Exchange (NYSE) as Ben S. Bernanke, chairman of the U.S. Federal Reserve, speaks on television in New York, U.S., on Wednesday, June 19, 2013.
Jin Lee | Bloomberg | Getty Images
Traders work on the floor of the New York Stock Exchange (NYSE) as Ben S. Bernanke, chairman of the U.S. Federal Reserve, speaks on television in New York, U.S., on Wednesday, June 19, 2013.

Everyone assumes that Treasury yields will rise when the Federal Reserve announces that it will pare back QE.

Like most things that everyone assumes, this could be wrong. Indeed, it probably is wrong because everyone assumes it.

When the Fed begins to taper, we might actually see a fall in yields. For one thing, yields have already been rising in anticipation of the Great Taper. The 10-year is up 50 basis points since May. So the Great Taper selloff may already be priced in.

Jim Hamilton at Econobrowser points out that the start of QE2 and QE3 was preceded by falling yields and sparked rising yields.

It's helpful to begin by looking back to when the Fed started the latest rounds of large-scale asset purchases. On November 3, 2010, the Fed announced its intention to purchase $75 B each month in long-term Treasuries through June of 2011, a measure popularly referred to as QE2. The theory was that these purchases would reduce the interest rate on those securities. But what happened over the next two months was the 10-year yield went up 60 basis points.

... One sees the same pattern in the figure above for the announcement on September 13 of the current bond-buying program (often called QE3). Rates dropped prior to the bond purchases, with little discernable change after the announcement itself. Again, markets anticipated the move in advance, partly because of statements from Fed officials, and partly because everyone could see signs of economic weakness in the U.S. and the recession in Europe.

It's easy to see that the reverse could happen when QE3 is curtailed. The beginning of the end of QE may be very different than what everyone expects.

—BY CNBC's John Carney. Follow him on Twitter @Carney

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