Pivotal period looms after summer of QE tension Many investors probably enjoyed a relaxing break during August. Not so US equity and bond markets. It's easy to look at the swings in asset prices this month and reflect that they were largely a function of absent investors and understaffed dealer desks. In thin illiquid markets, prices can easily jump around and, reflecting this development, we have seen equity and interest rate volatility jump back to heights they reached in June. Once the Labor day long weekend is negotiated, investors and dealers will once more become fully engaged with markets but, as September gets under way, a sense of trepidation will only increase. For next month truly shapes up as a pivotal period for markets as, after months of debate that has buffeted US equities and bonds, investors will likely discover how quickly the Federal Reserve will start reducing or "tapering" its $85bn of monthly bond purchases. This policy decision dominates other possible flashpoints for markets, ranging from key economic reports, military action in Syria, yet another Washington budget battle and rising stress across emerging markets. The question of the Fed tapering its bond purchases under quantitative easing cuts to the heart of the underlying tension that has characterised US markets this summer and already put a number of emerging countries with large current account deficits through the wringer. The beginning of the end for QE matters greatly as for the past five years, central banks led by the Fed have actively encouraged investors to pile into risky assets. With QE suppressing interest rates and more importantly, the volatility of prices, investors duly obliged and sought risky assets. Now with the Fed thinking about reversing some support, this summer's turmoil may be a taste of what is coming in the form of higher long-term bond yields and market volatility. Some will argue the Fed's taper is pretty much reflected by the sharp rise we have seen in long-term Treasury yields since May. With the Fed stressing that it is in no hurry to raise overnight rates, the bond market thinks there is a limit to how far long-term yields can rise from here. As a result, a 3 per cent 10-year yield is seen by many as characterising a ceiling in this key interest rate. Before the Fed meets next month, however, there is the risk that bond yields approach and rise beyond 3 per cent, particularly in the event that next week's release of the August jobs figure arrives on the stronger side of expectations and the Fed signals a taper of some $25bn rather than current hopes of a modest $15bn per month. In turn, equities would face further internal churning as interest rate-sensitive sectors languish while those that are more influenced by the economy find some support. Once the Fed's taper starts, equity bulls believe less QE is a vote of confidence in the economy and that is ultimately good news for a stock market, in spite of its substantial rally since last November. Certainly, Wall Street remains bullish on equities with many high-profile strategists forecasting the S&P will rise back above 1,700 and close out the year in record territory. But the wild card for markets in September is that, should the Fed set the ball rolling on less QE, investors could well decide a long period of low volatility is done and it's time to exit bonds and equities. Under QE, the mantra among investors was "don't fight the Fed," but once the central bank starts retreating, albeit slowly, from the printing press, the key market forces of liquidity and risk premia will play a more prominent role in how asset prices behave. ""Fed tapering" is more than a two-word phrase," says Lena Komileva at G Plus Economics, adding investors face higher market illiquidity and volatility risk premia that "creates uncertainty among investors about the natural clearing price for bonds and equities." For investors, it may well emerge that taking a break from the action during August was a wise choice as they will need plenty of stamina to negotiate any upsurge in market volatility in the coming weeks.