SocGen Taper Tantrum Post-Mortem: "FOMC On Track For September Tapering"

Who though that a term we coined over a month ago would suddenly get so much airplay: why, it was none other than billionaire hedge fund investor David Tepper who said days later (and just in time to top tick the market) not to fear the taper, that it is a bullish sign. Looks like it wasn't. But at least Tepper sold everything he had to sell by now so someone is happy. As for what happens next, nobody still has any idea, although the first, and so far best, post-mortem of Bernanke's predicament comes from SocGen, whose opionion is simple enough: FOMC on track for September tapering.

From SocGen:

FOMC on track for September tapering

Today, we expected Bernanke to provide more helpful guidance on asset purchases and on eventual exit steps. We got what we wanted. Bernanke reiterated that tapering is likely to begin “later this year” and end around mid-2014, i.e. when unemployment reaches 7%. Regarding exit principles, the only new colour was that the majority of the FOMC is now against ever selling the Fed’s MBS holdings.

Tapering guidance much improved

We’ve complained in the past that the guidance on asset purchases was too vague and flat out unhelpful. The Fed made a large step today toward addressing our concern. Rather than laying out specific conditions for tapering, Bernanke suggested that if incoming data is broadly consistent with the Fed’s forecast, it will be “appropriate to moderate the monthly pace of purchases later this year.” The Fed projects that the unemployment rate will average around 7.4% in the fourth quarter (vs. 7.6%) today, which implies that the Fed sees a 7.5% level or thereabouts as consistent with tapering. After that, Bernanke suggested that the Fed will continue to reduce the pace of asset purchases through the first half of 2014, or until unemployment falls to roughly 7%. This would imply a roughly $10bn reduction in asset purchases per meeting.

The new guidance on tapering is broadly consistent with earlier hints, notably with the three conditions laid out in the minutes of the May meeting. At that time, most participants saw three criteria for tapering: continued progress on employment, improved confidence in the outlook, and reduced downside risks. It was probably not coincidental that the only changes in today’s FOMC statement alluded directly to two of those three conditions. First, in the economic assessment, the language on labor market conditions was changed from “have shown some improvement” to “further improvement”. And, the statement significantly downgraded downside risks to the economic outlook.

Back to data watching

The Fed’s economic forecasts have become an implicit benchmark against which investors should be evaluating incoming data and re-pricing the timeline on asset purchases. The Fed expects growth to average around a central tendency range of 2.3%-2.8% (or a midpoint of 2.5%) this year. Since Q1 GDP expanded by 2.4%, i.e. broadly in line with the full-year forecast, we simply need to see more of the same. Employment growth has averaged at 175,000 jobs per month so far this year vs. 80,000/month trend growth of the labor force. A mere continuation of this performance will continue to put downward pressure on the unemployment rate.

Our central scenario

We maintain our call for a September tapering. Prior to today’s meeting, we had assumed that asset purchases would come to a full stop by the January meeting. While Bernanke’s guidance suggested that buying will continue until mid-2014, our own forecast trajectory hits the 7% level of unemployment a bit earlier, before the end of Q1. We therefore still see the risks skewed toward a shorter tapering cycle than consensus currently assumes. After that, there is likely to be a long pause in Fed policy. Rates are still on track to remain at zero until 2015, and in fact Bernanke hinted that at some point the Fed could lower the 6.5% threshold for rate hikes. We assume that MBS runoff and reserve draining operations will begin about 6 months before the liftoff in rates, i.e. in late 2014. MBS asset sales now look unlikely, but it is not clear at this stage whether the Fed will reduce its Treasury holdings through sales or redemptions, or simply maintain a large balance sheet and allow the economy to grow into