July 10, 2013

Quantitative Hardening

After unleashing the speculators in mid-June, the Fed carnival returns to the trading arena to set the record straight.

The now-famous June 19th FOMC meeting has come and gone – leaving a trail of shocked and awed speculators in its wake. The Fed ZIRP gravy train has been quietly supporting equity, commodity, credit and bond markets since 2008 so even a hint of that sweet gravy being taken away, pushed swathes of speculators towards the exits. 

Short-term yields have surged higher since June 19th and consolidated while USD strength has only taken on added momentum, supported by rising yields and a distinct policy divergence between the Fed and all other G20 central banks. EUR, GBP, JPY and even CHF have all fallen sharply against USD over the past few weeks.

Note: For a detailed analysis of the June 19th meeting, read our previous post titled ‘The Fed has pencilled in a shift of QE policy - but can the markets bear it?

Meeting Recap

Markets went into the June FOMC meeting looking for more guidance on tapering and the policy outlook. The policy statement had was largely unchanged from the previous month so the most significant adjustments were in the second paragraph where it was noted that -
"Downside risks to the labour market and economy have diminished since the fall"
  • The Fed maintained its $85bn per month pace of purchasing Treasuries and Mortgage Backed Securities (MBS)
  • The FOMC kept rates at 0%-0.25% conditional on unemployment remaining above 6.5% and 1-2 year projected inflation remaining below 2.5%
  • 15 of 19 policymakers expected no increase in the federal funds rate before 2015.
  • The FOMC meeting had two dissenters - James Bullard, who said that the FOMC “should “defend its inflation goal in light of recent low inflation readings” (dovish bias) and Esther George who maintained her hawkish bias and dissented for the fourth consecutive meeting, continuing to cite concern that keeping interest rates near zero risks creating “economic and financial imbalances including asset price bubbles".
  • On inflation, the FOMC stated: "Inflation is running below the FOMC’s longer-run objective partly due to transitory influences"
The most important aspects are often the most overlooked – especially in the speculative, knee jerk, temper tantrum markets that we see today. One comment that stood out above all others, and the one that may offer the best clue on this week's minutes was:
"If you draw the conclusion that our purchases will end in the middle of next year, you’ve drawn the wrong conclusion, because our purchases are tied to what happens in the economy. If the economy does not improve along the lines that we expect, we will provide additional support."
We have not seen consistent macro data from the U.S since the financial crisis and we haven’t seen a single Fed/IMF/WorldBank/OECD/BIS/Goldman/JPMorgan estimate match eventual outcomes. It seems that central bankers, politicians and investment bankers are constantly expecting great results only to be disappointed. Being so consistently wrong, in so many different aspects has not done any of the above ivory towers any harm. 

The markets still hang on their every prediction as if it was scripture. The reality is that GDP, employment, spending, incomes and investment are all anaemic in the U.S. and are likely to stay depressed for the foreseeable future due to the dystrophy in global markets, caused funnily enough by preceding Fed policy. U.S. GDP was revised lower from 2.4% down to 1.8% in late June.

Our core view is that the US economy remains troubled and weak despite the improving jobs numbers. In several posts on our TradersCorner blog, we have discussed the validity of those figures and reported the true level of US unemployment which is approximately 20-25%. Consequently, we see this week’s FOMC minutes (and Bernanke’s speech that follows), indicating a more dovish approach which the Fed miscommunicated on June 19th. Pushing back against the market and delaying tapering expectations would be very USD negative and would help all FX pairs retrace their extensive moves since June 19th.

What can the FOMC minutes change?

The FOMC minutes should clarify where the Fed stands but market participants will probably blur that clarity via speculation and herd behaviour. There is a strong possibility that the Fed attempted to talk the market away from expecting cheap liquidity but unintentionally overshot its target leading to undesirable market moves. We could potentially see a re-wording of previous Fed commentary and additional comments made this Wednesday in an attempt to reset market expectations of QE tapering.

The minutes will probably rehash most of what has already been addressed in the post-meeting press conference or via Fed speakers in terms of tapering and the baseline policy forecast. Fed members were sent out like orators on a battlefield – shouting at the top of their voices whilst the bullets were flying in every direction. Market participants haven’t listened and are now speculatively positioned for QE tapering to begin in September, end of 2013 or 2014 (depending on the source).

What this consensus misses is that not a single U.S. macroeconomic indicator can show consistent recovery. Most macro data has been contaminated by Fed liquidity and speculator after-effects so even indicators such as non-farm payrolls, business sentiment PMI’s, consumer confidence, CPI and many others are largely biased towards better numbers because of the hugely risk-on/risk-tolerant effect of Fed stimulus over the past 4-5 years.

Can the Fed allow policy tightening expectations to form under a cloud of debt, anaemic GDP and stagnant economic conditions? Probably not. And they’re doing their best to halt the grind higher in short-term bond yields by talking the market out of believing its own earlier statements.

Alternative scenario

The general tone from the June 19th meeting was optimistic about the ongoing recovery but cautious regarding how to exit QE. We see an alternative possibility of the Fed holding course and defiantly accepting the recent market moves. In this case, it will be important to look out for continuing hawkish commentary about U.S. economic improvement etc. 

We will be keenly looking for additional insight on the timing of a tapering decision because the Fed may want to be more precise in telegraphing their intentions. Market expectations of QE tapering (i.e. a reduction in the $85bn per month of purchases) have been brought forward to September 2013 whereas the Fed may see that as a bit optimistic. We could see a continuation of its hawkish stance but with a delayed timeframe – which is dovish as far as the market is concerned because of what’s been priced in since June 19th. 

Consensus at the Fed is likely to favour December 2012/January 2013 regarding tapering, though it would be unsurprising to see more aggressive calls, perhaps as early as July amongst the Fed’s staunchest hawks (Charles Plosser, Jeffrey Lacker and Richard Fisher).

Commissioned by Think Forex