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Market movements around this week’s Fed meeting

This week will be one of the most pivotal weeks for global markets as the Fed debates whether to start winding back on its asset purchase program (APP). 

There is quite a split among analysts expecting tapering to begin in December, January or March. We have heard countless times from Fed officials saying APPs were not on a preset course and will be adjusted accordingly as the data improve/worsen.

Back in September, tapering was almost a ‘done deal’, but this proved not to be the case with one of the main reasons being significant fiscal downside risk given the pending US budget and debt ceiling negotiations.

At the same time the jobs market hadn’t quite improved to the level the Fed would have wanted to see before starting to taper.

Potential markets affected by this week’s Fed meeting

Key asset classes to look out for following the Fed meeting on Thursday will be treasuries, USD crosses, gold and the S&P, along with other equity indices.

Arguments for December tapering

As things stand, the US economy has come a long way with non-farm payrolls printing around 200,000 and the unemployment rate dropping to 7%. This is perhaps the strongest argument for tapering at the moment. Growth data has also picked up along with manufacturing since the October meeting,  but inflation remains a bit of a concern.

Most importantly though, a key hurdle on the fiscal front has been removed as the US achieved a longer lasting fiscal agreement earlier than most anticipated. Just from a Fedspeak perspective, there has been mounting pressure on the Fed to start tapering, with doves like Charles Evans even giving some reasons for the tapering argument. The Fed has insisted that tapering is not tightening and the Fed funds rate should continue to support ultra-easy monetary policy.

Markets to watch if tapering begins this week

Should tapering begin this week, treasuries and the US dollar are likely to be the first assets to react. In such a situation, we are likely to see gains for USD/JPY, while risk currencies like AUD/USD fall as the US dollar strengthens. Correlation wise, a stronger USD would weigh on commodities, with gold being a likely culprit.

Against December tapering

On the other hand, a major deterrent for the Fed which might warrant a bit of caution will be the debt ceiling negotiation. An article in the Financial Times suggesting that the Republicans plan to demand concessions from the White House in exchange for lifting the debt ceiling is gaining momentum. Comments made by Republican chairman of the House budget committee Paul Ryan sound quite aggressive and perhaps this will stall the Fed.

While data in the US has shown strong signs of improvement, inflation has fallen further and James Bullard recently said he would like to see a pick-up in inflation before starting to taper. Although jobs numbers have improved remarkably, participation and wage growth have remained benign. Questions are also being raised about whether the Fed is ready to strengthen its forward guidance just yet given mixed comments from recent meetings. The unemployment rate is very close to the Fed’s threshold for raising the funds rate. With inflation remaining weak, analysts feel any tightening of conditions will put significant pressure on its 2% inflation target being achieved. While Fed members are getting ‘comfortable’ with tapering talk, there is still no real consensus on key issues like lowering the unemployment threshold.

What to trade if the Fed doesn’t taper

Should the Fed choose not to press on with tapering, we are likely to see US markets bid higher with investors taking advantage of recent weakness. Such a move could also drag the USD lower and lift risk currency pairs such as EUR/USD and AUD/USD. Commodities such as gold and copper would also be likely beneficiaries of this move.

January could be middle ground

Having said all this, the US economy is experiencing a remarkable recovery and the Fed has made it clear it wants to see the economy get to a stage where it is in a sustainable recovery before beginning to taper. The majority of analysts still expect tapering to only occur in March with a limited amount expecting it at this week’s meeting. January is perhaps middle ground and gives the Fed another month of data to assess before making the call.

A token taper around the $10 billion ball park has been cited by some as a possibility, with the Fed using it as an opportunity to test the waters so to speak. Should it continue to see a good run in data from there, then it can look at steadily winding back from March onwards with a bit more clarity from the debt ceiling conclusion. 

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