Scotiabank: The Fed's Increasing Optionality And The July 31 Taper

Via Guy Haselmann of Scotiabank,

The Fed – Increasing Optionality and Weeding out the Noise

If Fed action was based solely on getting the economy to a desired growth level, tapering discussions may not have arisen yet. Instead, the Fed likely would have continued to ‘buy’ as much time as possible to allow the economy to ‘heal’ further; and to get better clarity on the impact of the Sequester and outcome of budget negotiations.

In reality and as I have emphasized all year, Fed policy has to also weigh the costs, the risks, and the unintended consequences of buying assets at such an extraordinary pace. These concerns, combined with a slightly more optimistic FOMC, are why (the Minutes reported) ‘several’ members said a reduction in the amount of asset purchases is warranted and “half of the FOMC” wanted to end QE before the end of the year. At this point, the market would not be surprised at a tapering announcement as soon as the September meeting.

However, for a number of reasons I believe the FOMC is short an option by waiting two full months until September 18th to announce a reduction in asset purchases. If the FOMC is indeed worried about the risks of QE, Bernanke may wish to raise the FOMC’s optionality and flexibility by getting the market to believe a tapering could occur as soon as the July 31st meeting. Certainly, the longer the Fed waits, the more costs mount.

Since ‘several’ members seem to want to slow purchases immediately, doesn’t it make sense for Bernanke to maximize the FOMC’s flexibility? During his May JEC testimony, Bernanke used the words “later this year” when discussing the timing for a slower pace of asset purchases; so, couldn’t Bernanke increase FOMC optionality simply by not using those words tomorrow?

Tradition usually maintains that Fed Governors vote with the Chairman. There are only a few examples over the past thirty years of dissents, but they usually correspond to minor rule changes, rather than major policy changes. Bernanke is a Chairman who is highly respectful of the opinions of his colleagues. Since his term as Chairman expires in January, he will be less inclined to impose his will on the others who will remain after his departure. Therefore, the Governors concerns about financial stability, and exit strategy woes from a bloated balance sheet, could lead to a vote to taper at the July meeting. If so, then Bernanke should outline this possibility tomorrow (as he did not today).

The timing of the July 31st meeting (no press conference) presents some challenges to those may wish to taper ASAP. The meeting occurs on the same day that Q2 GDP is released. A majority of forecasts have Q2 posting a number below 1% which follows a downwardly revised 1.8% number in Q1. Announcing a tapering after such a weak growth number may not look good, despite the fact that low Q2 growth probably borrows growth from Q3. Furthermore, the July Employment report is released two days later on August 2nd. The FOMC will have most of the components of this report which could potentially skew the conversation in either direction.

Few doubted that Bernanke would use today’s testimony to clarify the Fed’s message without unnerving markets – emphasizing the differences between stimulus, accommodation, a hike in rates, and removal of accommodation. He will continue to say that tapering is merely a slowing in the amount of stimulus and that even after QE ends the Fed will still be “highly-accommodative”. All FOMC members will emphasize Forward Guidance as an offset to the slow removal of QE.

To soften the reaction to amplified discussions about tapering, Bernanke may also wish to say that higher rates may affect the Fed’s growth forecasts a little more. In such, Bernanke would be suggesting that if rates rise, QE might continue for longer. This would be consistent with a Fed that seems intent on managing market reactions and expectations.

The bottom line is that the market can finally see the beginning of the end of QE and therefore the risk versus reward in the Treasury market is in my opinion still to higher yields. The question becomes just how fast rates will rise. Either way, accounts should be short Treasuries, especially the belly of the curve.

“The only thing worse than being exploited by capitalism is not being exploited by capitalism. -Joan Violet Robinson


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