A cut in the pace of bond buying (taper)
A cut in the pace of its bond buying program (QE3) from say, $85 billion to $75 billion a month, is a 50% probability in my view. The recent data trends in employment certainly warrant a cut, as do manufacturing and a number of consumer-related data points. St Louis Fed member James Bullard (a dove) also recently disclosed that 'a small taper might recognize labour market improvement while still providing the [FOMC] the opportunity to carefully monitor inflation during the first half of 2014’. The issue of low inflation could hold them back, although the comments from James Bullard suggest they may cut and see how things go.
If they don’t taper in this meeting they will give a strong indication of a taper in the January or March meeting. Thus, on this point alone, a failure to move shouldn’t cause too much of a reaction in the markets, as long as the chairman gives a strong indication it is coming.
A cut to the interest earned on excess reserves (IOER)
The idea of cutting the rate issued to banks who park cash with the Fed has been talked about in the market and given there is around $2.5 trillion parked with the Fed currently earning 25 basis points, there may be a downside reaction in the USD if they cut this to zero, while US banks may also come under pressure. The rational for this move is to encourage capital to make its way into the US economy.
Whilst cutting the IOER has been talked about in the October Fed minutes, I personally think the probability of a cut to the IOER to zero tonight is actually very low as it would smash short-dated bond yields and would not result in higher lending in the real economy (in my opinion) and would see commercial banks simply pass on any costs to the consumer. The potential negative consequences here are simply too great.
A change to the Fed forward guidance
As things stand, the Fed has previously stated they will raise the Fed funds rate (its equivalent cash rate) when unemployment falls to ‘at least’ 6.5% and core PCE (personal consumable expenditure – the Fed preferred measure of inflation) moves through 2% and onto 2.5%. This is perhaps the most important issue and should be the trigger that provokes the greatest volatility in the market. Most feel that if the Fed taper, they will need to accompany this with an altering of its forward guidance thresholds for putting up the funds rate. Given the current unemployment rate is only 50 basis points above the level the Fed have suggested they could move on rates, then the prospect they strengthen this guidance to 6% or even 5.5% is high.
In November, Bill English (the most senior economist at the Board of Governors) presented a paper to key officials, and the key take-out was Mr English saw the optimal unemployment rate for the Fed was 6% or below.
Changes to the Fed economic projections
In the upcoming meeting, the Fed get a chance to update its economic projections (also due at 06:00 AEDT) and there could be some modest alterations to forecasts. In terms of growth, the Fed currently see (using a mid-point) 2.2% in 2013, 3% in 2014 and 3.25% in 2015. Given the trends of late, these forecasts could see upside risks. In terms of core CPE, the board projection stands at 1.25% in 2013, 1.6% in 2014 and 1.9% in 2015. On the employment side they see the unemployment rate at 6.5% in 2014, 6% in 2015 and 5.4% in 2016. The prospects of altering its inflation forecasts is also high and would mean they have cut their view on inflation every quarter this year.
Reaction in the markets
Naturally the playbook is a complex one, given they could easily detail one of these events and leave others alone. Much will be made of the tone of Ben Bernanke and how upbeat he sounds on the future of the economy and importantly; his concern around the upcoming US debt ceiling debate in February.
If we simply see a taper to its bond buying program and no change to its forward guidance then I’d expect the USD to rally, while stocks, gold and bonds could suffer as many expect both to be announced together. We could see a taper and a strong indication of a future move in forward guidance and this is a strong possibility as the Fed speakers haven’t been overly interested in changing this guidance lately. It is imperative that the Fed hammer home the message that ‘tapering is not tightening’.
Around 60bp of hikes are being priced into the markets, so even if the Fed does taper and lower its guidance for hiking the funds rate when unemployment reaches 6%, it is largely in the price already. The major reaction will come if the Fed alters its guidance around unemployment to 5.5%, in which case I expect a strong rally in the short-end of the bond market (especially the two-year), while gold and equities could find buyers. The USD would be offered, especially against the likes of the JPY and CHF.
We may see nothing at all from the Fed, although they would give a strong indication a taper is on the cards. This is a strong possibility as well, which could be USD negative. I would use this as a buying opportunity though, especially against the JPY, given the market will start to expect this action in January.