Global Markets research
9 September 2013
FOMC preview: Tapering and tempering
We expect the FOMC to taper its monthly asset purchases from USD 85 billion to USD 75 billion on 18 September.
However, we see a risk the FOMC is dovish, leading to a small and temporary fall in the USD after the announcement.
In the absence of deterioration in Syria, we would use a post-FOMC fall in USD/JPY as a buying opportunity. We expect USD/JPY to lift to 106.0 by year-end.
US economic trends suggest tapering is likely this month
Ahead of the FOMC’s 17-18 September policy meeting, market participants are likely to re-evaluate the risk of tapering asset purchases following the softer than expected non-farm payrolls report. Non-farm payrolls for August fell modestly short of expectations (169,000 versus consensus of 180,000) and job gains in earlier months were revised down. The USD is likely to consolidate this week as a result of the uncertainty introduced by the weaker than expected payrolls report.
We have not changed our view from the current issue of the CBA International Economics Monthly released on 16 August: "We expect the Fed to begin tapering asset purchases in September 2013 but we acknowledge the risk of a one or two meeting delay”. On balance, we consider the US economic data to be strong enough to give the FOMC confidence the US economic recovery can withstand a tapering of asset purchases in September rather than wait for another meeting or two. Some of the important economic indicators suggest momentum in the US economy is now stronger than during QE2 and that QE3 has been more successful (chart 1).
In Chairman Bernanke’s words, "when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 per cent, with solid economic growth supporting further job gains”. Rhe US unemployment rate is currently 7.3% compared to 8.1% when the FOMC announced QE3 in September 2012. The FOMC appears to have met its condition of the unemployment rate being in the “vicinity of 7%” early. In June 2013, the FOMC forecast the US unemployment rate would be at 7.3% in December 2013 (chart 2). Whether the FOMC will choose to taper its asset purchases in September will hinge largely on its economic forecasts. We expect the FOMC to leave its new economic forecasts broadly unchanged – there is a risk of small downgrades to both US GDP growth and the US unemployment rate – and proceed with tapering this month.
What kind of tapering?
Given the uncertainties about the US economic outlook, we expect the FOMC to take a cautious approach. We expect the FOMC’s first step towards tapering asset purchases to be modest. Our baseline is the FOMC tapers its asset purchases from USD 85 billion per month to USD 75 billion per month in September 2013. We do not expect the FOMC (nor Bernanke at his accompanying press conference) to indicate the size of the tapering steps beyond the September meeting. By not committing to future tapering steps, the FOMC will give itself flexibility to respond to possible changes in the US economic outlook.
We expect the FOMC’s first tapering step to be as follows: (i) cut monthly Treasury purchases from USD 45 billion to USD 40 billion; and (ii) cut monthly agency mortgage backed securities (MBS) purchases from USD 40 billion. Given Bernanke's Comment in June that "a dtrong majority (on the FOMC) now expects the committee will not sell agency mortgage backed securities during the process of normalisation", the FOMC may choose to taper only its Treasury purchases from USD 45 billion to USD 35 billion per month. The FOMC would choose this path if they judge that the US housing market is at risk from a further spike in US mortgage interest rates. Mortgage refinancing has fallen sharply in recent months (chart 3)
Fed communication and FX implications
FOMC meeting are very influential on market pricing during 'normal times' (chart 4 is from recent research from the New York Fed). These are not normal times. QE policy is uncharted territory for the FOMC. Therefore, it is conceivable, though unlikely, there is a large currency market reaction to the release of the FOMC statement and/or Bernanke's press conference of 18 September
Our sense is a majority of market participants still expect the FOMC to announce it will begin tapering its asset purchases on 18 September, despite the weaker than August expected non-farm payrolls report released on 5 september. The yield on US Treasuries eased by only 6 basis points in response to the payrolls report, compared to the 100 basis point gain since Bernanke indicated on22 May the FOMC may taper asset purchases "in the next few meetings" (CHART 5)
According to Bloomberg, 24 of 34 Us economists surveyed on 6 September (after the release of the payrolls report) expect the FOMC to taper its asset purchases at the 17-18 September FOMC meeting. The survey indicates the FOMC will taper monthly Treasury purchases from US 45 billion to USD 35 billion but maintain MBS purchases at USD 40 billion - the same result from Bloomberg's 9-13 August survey.
We consider modest amount of tapering is largely prices into the USD (and Us swap rates). If there is to be a market reaction to the FOMC's decision on 18 September, the catalysts are likely to be: (i) whether the post-meeting written statement is perceived to be dovish or bullish; (ii) changes the the Fed's forcasts and (iii) Bernanke's guidance (if any) during the press conference.
We expect the Fed to taper and temper. We expect the FOMC to taper asset purchases modestly and deliver a dovish message in the post-meeting statement and/or at Bernanke's press conference. We also expect the Fed will want to temper market expectations that tapering will be rapid or the the FOMC participants have brought forward their expectations for the first increase in the funds rate. We expect Bernanketo emphasise that tapering is not policy tightening and that the first tightening of monetary policy by the FOMC is a long way off. A tightening of policy would be the FOMC reducing its balance sheet (ie selling assets of allowing assets to mature rather that taper purchases) and/or increasing the funds rate.
We also expect Bernanke to emphasise that if the US economic recovery stalls for some reason, the FOMC with change tack by keeping asset purchases constant for a period or even increasing purchases.
Overall, with a week and a half until the FOMC meeting, we see a risk the FOMC is more dovish than expected, leading to a small and temporary fall in the USD. However, our long-held view that the USD is in a multi-year uptrend and the yen is in a multi-year downtrend has not changed. In the absence of a deterioration pf the situation in SYria, we would use a post-FOMC fall in USD/JPY as an opportunity to buy. We expect USD/JPY to lift to 106 by year end.