Thursday, November 21, 2013

Fed Drops A Strong Hint and a Cold Shower

Yesterday, investors and traders sold equities, gold and all sorts of investments on changing attitudes toward the time frame of a Fed taper, which apparently they now think will happen sooner rather than later despite a persistently weak economy. I am likely wrong here, but if you take the Fed's comments about being data dependent at face value, the belief that Yellen is more of dove than Bernanke, and the research/comments from BCA Research below then any tapering action by the Fed is likely farther out than is otherwise believed. Possibly even out to a year.

And of course, the below research just extrapolates the current environment out for a few years. Considering that the economy is only growing at a 1.6% rate year-on-year while employment levels accelerate to the downside, how much stock can we hold that the present environment will keep a steady pace for years out? 

Two research reports from high level Fed staffers dropped strong hints at the direction of policy.
Fed Drops A Strong Hint
The first report reinforced the importance of keeping the policy rate glued at zero far into the economic recovery and allowing a modest inflation overshoot down the road, in order to provide maximum stimulus today and reduce the time it takes to get back to full employment. The authors simulated the economic effects of different policy rules, including raising the inflation target and nominal income targeting. However, they argued that the former does not provide a meaningful improvement in the outcome, while the latter would be difficult to explain to the public.

In contrast, they found that lowering the unemployment threshold contained in the forward guidance from 6.5% to 5.5% would make a substantial improvement in terms of returning to full employment.
The second paper reinforces the key message by arguing that the longer that demand growth is weak and an output gap persists, the more (permanent) damage is done to the supply side of the economy as labor skills dull (i.e. the hysteresis effect). The implication is that the Fed should be as aggressive as possible in order to minimize the permanent loss of potential output in the long term.

The FOMC appeared to be leaning toward adding an inflation threshold to the forward guidance at the last meeting, rather than changing the unemployment threshold. Nonetheless, we see these two policy papers as an important signal for the direction the FOMC is heading. The researchers are part of a group that focuses on policy rules at the Fed, which has been a key driver of Fed thinking on these issues (for the doves at least).

Thus, the two papers reinforce our long-held view that the FOMC will combine the tapering announcement with a reduction in the unemployment threshold, probably to 6%. This will make it clear that the Fed is changing the policy tool focus from QE to forward guidance.

Assuming average payrolls of 200,000, the unemployment rate will require an extra 11 months to reach 6%, compared to the 6.5% threshold. Given the historical relationship with the lift-off date, on its own this could reduce the 10-year yield by a whopping 50-75 basis points. However, the impact would likely be dominated by the announcement of tapering, which would cause the term premium to rise.

Bottom Line: The FOMC will try to limit the damage to the bond market when it announces tapering with changes to the forward guidance. The market’s reaction will likely depend on the economic backdrop at the time. If growth is still struggling at around a trend pace, Treasurys would likely rally. But if growth is above trend, then Treasurys are likely to sell off on the combined announcement.

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