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Monday June 17, 2013 - 21:55:23 GMT
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Fear tightening not tapering (FXA)

Fear tightening not tapering


Hilsenrath last Wednesday served up the latest deep background from the Fed (Bernanke surrogate surely) leaving little doubt that the Chairman and his consensus is very much in synch on beginning the process, however long, of winding down QE3 – slowing the pace of balance sheet expansion and this should not be confused with raising rates when QE3 gets to zero for instance. The criteria for raising rates are considerably higher and are not in Fed forecasts until late 2014. Indeed the back up in Fed funds and Eurodollar futures has the Fed worried its message is being misinterpreted by markets (see WSJ’s JH) – confusing tapering with tightening. That may be the case in some instances, but markets are not always prone to the rational thinking, least of all as the Fed sees what is rational – markets more often than not zip right past equilibriums in an often vicious circle of overshooting and undershooting.


If I were the Fed I would be far more concerned about the rise in long-term rates since April choking off the recovery – tighter financial conditions. Indeed my more cynical take is that is precisely what the Fed is worried about and eager to see at least partly unwound. The last thing the Fed wants at this stage of the recovery is for overshooting bond yields killing the housing market recovery. Some back up in rates is fine for the Fed, but over 70bps on the 10-yr is more than simply pricing in a better US economic outlook and higher inflation – it is a trade, trend and who cares what the Fed thinks the market thinks about tapering and tightening. It is survival time. Selling of UST begets selling. Animal spirits are in charge not rational expectations.


My point on tapering is more or less just do it. The more the Fed “prepares” markets for a change the more confusion (high volatility) seems to ensue. Also slowly working in the notion of tapering means the risk of data souring rises making tapering more uncertain the longer it is delayed. If the Fed’s motivation in part is to take some of the froth out of asset prices pumped up with QE3, then talking incessantly about it, assuring it won’t end all at once and could be turned back up if data warrant undermines its capacity for checking thinks like the trajectory of the stock market. If we end up Wednesday PM believing a Fed Chairman pitching the very benign nature of tapering (still means easing as balance sheet grows indefinitely just at slower pace) then it risks not achieving what many think is a key aim – check risk asset prices at risk of overshooting.


I simply have a hard time believing the Fed has a lot to go on for reducing a program that it started in an economic environment not too dissimilar to the one we are currently in. The labor market is producing more jobs but the kind of jobs are mainly low paying service sector jobs and more recently temporary jobs are a key component in service sector jobs – third after hospitality/food – just behind. And the unemployment rate fell mainly reflecting people leaving the workforce – boomers for retirement and discouraged workers – and not because of new jobs being created in a meaningful fashion. Housing and autos seem to be doing the best on the goods producing side but are still well off pre-crisis peaks.


So I am in the camp that the basis for market misunderstanding is that few believe the Fed’s basic assertion/assumption on the economy approaching some escape velocity that warrants the start of monetary policy normalization (even if that escape window in later in 2014) – even at the fringe in form of tapering of QE. I think the markets get it – they are not sharing the Fed’s confidence level on the sustainability of the recovery absent massive monetary if not fiscal support.


Which leads me to why is the Fed pulling back a program not even 12 months old? It must be financial stability concerns – QE inflating risk asset prices and some desire by the Fed to try and check it – tapering is a safety release valve on overshooting stocks and high yield. Surely some markets reacted in this fashion – EM, high yield. mortgages and Treasuries if not stocks.


So we don’t have a Cool Hand Luke problem – a failure to communicate (markets confusing tapering with tightening). We do have a messaging problem - the Fed’s message is a hard sell. It is in part an emperor’s new clothes story. Unless data sets ahead turn remarkably more upbeat, the harder it will be for the Fed to shoe horn in even modest tapering. It is time for the Fed to just move – stop the spoon feeding, hand holding. Bring on tapering and let the chips fall where they may (bulk of fall through last week would suggest little additional carnage).


David Gilmore



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