by Guy Haselmann, Director, Capital Markets Strategy, Scotiabank
The market is highly confident that it has a good handle on tomorrow’s FOMC meeting, despite the fact that several factors will require modification. There is high conviction that the Fed will not surprise the market, but rather take a “steady as she goes” approach that delivers a market consensus outcome. The reasons for this view are obvious and logical; however, such complacency breeds risk as well as opportunity, because the arguments for accelerating tapering to $15 billion (per month) are quite compelling (as I outlined in my note on June 10th).
Interestingly, a consensus result still has traders debating how markets will respond and which variables are the most important. Part of the problem is the mixed messages and cross-currents being delivered by the FOMC. For example, the FOMC is talking uber-dovishly with forward guidance, while simultaneously reducing accommodation via ending the QE program. Its words are dovish, but its actions are not. In addition, the central tendency forecasts for GDP and the unemployment rate for 2014 will both be lowered. The first is dovish, but the other is not. Market confusion remains high, because Fed communication is poor and these factors provide ‘something for everyone’.
The most tradable and talked-about unforeseen change is likely to come from variations made to the ‘dot plot’. There are two sets of ‘dots’. The first set is derived from each FOMC member’s prediction for the optimal ‘target federal funds rate at year-end’ for 2014, 2015, and 2016. Tomorrow, there will be 19 dots with three new members voting: Governor Fischer and Brainard, and new Cleveland Fed President Mester. This dot set is likely to be consistent with forward guidance ‘promises’ and their emphasis on being ‘gradual’.
The second ‘dot’ set is the expectation for the appropriate ‘longer-run’ or ‘normal’ federal funds level. Recent assessments have maintained this level near 4%. It seems inconsistent that the FOMC is forecasting full-employment and 2% inflation for 2016, yet its median federal funds target for year-end 2016 is 2.25%. If the dual mandates have achieved their optimal objectives, then why isn’t the FOMC’s 2016 target equal to the longer-run target of 4%? Does this mean that the longer-run target could slip tomorrow to 3% or lower?
The Fed has said repeatedly that it is “not on a preset course” and that it is “data dependent”. Based on this mantra, investors should not be so entrenched or wildly surprised if the Fed accelerated tapering to $15 billion. When I outlined these arguments last week, many responded with entrenched comments such as ‘you’re crazy’, or ‘the Fed will never change course’.
The timing to accelerate QE reductions to $15 billion is ideal. There are benefits to reminding markets that the Fed is truly ‘not on a preset course’. It is always better for markets, and the Fed’s long run credibility, when investors know that it has flexibility and is adaptable. Moreover, the data has certainly been better lately, therefore the move would indicate confidence to the market that the economy is gaining momentum and has healed adequately.
In addition, the new ‘dot plots’ would also partially offset the market’s reaction of ending QE sooner. In other words, accelerated tapering would cause markets to price in an earlier first tightening (in Q1 2015 rather than Q2 2015), because the market believes such will occur 6 months after the end of QE (which would imply August vs. October). Therefore, the new ‘dots’ are likely to show a Fed that is intent on raising rates only gradually and cautiously; thus, partially muting the reaction of QE ending sooner.
Exiting from QE by the end of the summer would also increase FOMC flexibility by freeing up the September FOMC meeting. Additionally, the Fed could use the July Humphrey Hawkins testimony and the August Jackson Hole meeting to fine-tune policy. Other reasons include: global rates and credit spreads near historical lows; equity markets at all-time highs; and the economy showing advancing signs of improvement. Since the risks of financial stability and froth expand past economic benefits with each passing day, the Fed should be incentivized to exit QE ASAP.
A market note discussed this morning stated that the S&P 500 has gone 40 straight trading days without having a 1% move on a closing basis; the longest since 1995. There have been only three instances since 1980. This is likely the result of six consecutive years of extreme Fed policy motivating one-way moral-hazard risk-seeking trades. If the FOMC is not aware of this and worried, it should be.
If the market and our $17 trillion economy can’t handle the Fed buying $5 billion fewer securities next month, then we are all in big trouble. Time presently works against the Fed. Geo-political tensions could morph dangerously at any time. Global economic cracks could also arise quickly from policy maneuvers in China, Japan or elsewhere. Hence, tomorrow’s meeting provides a great opportunity for the Fed to move the calendar more in its favor.
“Don’t think there are no crocodiles because the water is calm” – Malay Proverb
Regardless of whether the FOMC decides on a consensus outcome or a speed-up in the pace of tapering, I still like owning the back end of the Treasury market outright and opportunistically trading into and out of a flattener --- Covering front end shorts when the market prices too many hikes too early in advance . (I still believe 30’s will breach 3.00% and the 5’s/30’s curve will move below 100 bps.)
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Copyright © Guy Haselmann