The global capital markets have been feeling the effect for several months and now the cause is at hand. The Federal Reserve is set to decide whether to continue at the same pace the purchases of long-term assets or slow those purchases.
We have argued that if the Fed does taper, it is not because the economy is overheating. Nominal growth during this recovery has been, and continues to be, weak compared with other recovery periods. Prices pressures remain low and the Fed seemed to give this fact greater emphasis at the last FOMC meeting. Unemployment has comes down, but this is due to an undesirable decline in the participation rate. This year's average monthly job growth is slightly slower than last year's.
Polls in recent weeks have been fairly consistent, with roughly two-thirds expecting the Fed to taper. Many of the remaining third expected the tapering decision to be announced in Oct. There is a segment of the investment community that has never been in favor of QE; does not think it is effect, and is happy to see it end at the earliest possible opportunity. There is another segment that understands the QE was meant to shove the economy forward, not nurse it and that it has fulfilled this function, as much as it can.
The most compelling argument for the Fed to taper is that the market is giving it to them. This gift is can be seen in the US 10-year yield that has risen from 1.6% to 3%. Indeed, our base case is that US Treasuries can rally on a tapering announcement. That is the gift. Of course, guidance from the Federal Reserve, despite criticism of its communication, was instrumental in facilitating the gift, though it is probably a larger gift than it might have anticipated.
Expectations of the size of the tapering has itself been tapered. The consensus appears to be for $15 bln (split $10 bln less Treasuries and $5 bln less MBS). The road map Bernanke has sketched out calls for the Fed to able to stop QE entirely around the middle of 2014. However, it is not clear that the new Chairman (and for that matter, the new Federal Reserve as several governors are likely to step down and at least one regional president that was to rotate on to the FOMC as a voting member next year has already resigned) is obligated to that time frame.
The tapering could become a slightly more drawn out process, especially if our suspicions are right, and that the economy remains highly dependent on low debt servicing costs since the household debt level remains largely the same when one makes allowances for foreclosures. The impact of the rise in market rates in the US appears to already be adversely impacting the housing market. New homes sales can be volatile, but the 13.4% decline in July, warrants closer attention going forward. Mortgage applications have falling in fifteen of the past 18 weeks. Five year lows were seen earlier this month. The other key interest rate sector, autos, are holding in better, but are likely be closely watched.
We hasten to add that it is not just monetary policy that is becoming less stimulative. Fiscal policy is also tightening and it may tighten further as part of the compromise over the debt ceiling. Perhaps the economy is strong enough for fiscal or monetary policy to become less accommodative, but both, at the same time?
There are two patterns of the Fed's behavior that are also important to bear in mind. First, the Fed has under-estimated that the economy's dependence twice since 2009, in the sense of ending the asset purchases only to resume them. Second, and related, is the Fed's near chronic exaggeration of the strength of the economy as reflected in their GDP forecasts.
This puts the Fed in an awkward position tomorrow. If it announces tapering, it will likely be doing so in the face of reducing its growth forecasts (2013 2.5% midpoint and 2014 midpoint 3.3%). We note that is has been eight years since the US economy grew by more than 3% for a year.
The Fed's tapering may also be tempered by further tweaking of the thresholds for policy reconsideration. There had been some talk that the 6.5% unemployment threshold could be lowered. However, this seems less likely now. Speculation has shifted toward providing an minimum inflation threshold, below which monetary policy will not be tightened. We have become less enamored with such a course on the grounds that it would seem to further entangle the Fed without necessarily getting more that it can through strengthening its July statement that persistent below target inflation (2%) poses economic risks.
From a strategic point of view, it arguable makes little sense for the Bernanke Fed to begin the tapering. Whatever credibility is won does the Bernanke Fed little good. It will go down in history for its extraordinary easing and taking a foot of the accelerator in his last few months in office is really of little significance. Moreover, as we have suggested above, it complicates things for the next Fed. Better for all involved, if the new chair, whomever it is, begins the exit process. They will have the maximum degrees of freedom and will mark a new era. That said, Yellen's appointment would arguable make the distinction less significant as she represents the greatest sense of continuity.
We accept the idea that the way money is really made in the market is not so much by predicting the future as assessing the odds. Broadly speaking and relative to expectations, we think there can be only three scenarios: the Fed does what the market expects, it does less or it does more. Only in that third scenario would we expect the dollar to rally and Treasuries to sell-off. We subjectively attribute less than a 10% chance of the Fed being more aggressive than the market expects.