Taper Time – No matter what the Fed says today, markets are probably going to get crazy

This morning, the S&P 500 Index e-mini futures (ES-U3) are trading higher by just 0.50 points to 1705.50 per contract. Most institutional traders and investors are eagerly awaiting the FOMC announcement. Later today, the Federal Reserve is expected to start tapering its QE-3 program. QE-3 is a program where the central bank buys $85 billion a month of U.S. treasuries and mortgage backed securities. How much money will the Federal Reserve cut from the $85 billion a month program? That is the big question that most investors are asking.


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Why no matter what the Fed says today, markets are probably going to get crazy

Today’s Federal Reserve decision is momentous for a number of reasons.

Foremost among them: the Fed’s monetary policymaking body, the FOMC, is widely expected to announce the first reduction in the pace of monthly bond purchases under the open-ended quantitative easing (QE) program it introduced exactly a year ago.

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In a broader sense, this first “tapering” of QE represents the beginning of a shift away from the easy-money policies that have dominated the monetary policy landscape over the last five years coming out of the financial crisis and recession.

There is some debate over how big of a reduction in bond purchases the Fed will make, but the consensus is that the central bank will elect to taper by $10 billion, bringing total monthly purchases down to $75 billion.

If the taper is bigger or smaller, markets could move. But there are a lot of other outcomes from today’s announcement that could move markets as well, as Citi currency strategist Steven Englander reminds clients in a note this morning (emphasis added):

Today’s FOMC carries volatility risk, not because the policy decision is likely to signal a dramatic surprise but because there are an unusual number of dimensions along which FOMC can surprise, and whose implications will be debated. This includes timing and magnitude of tapering, 2014-15 forecast changes, 2016 first forecast, shift in the threshold for unemployment, a potential inflation threshold, among others. So the order of the headlines may determine extreme volatility until markets settle down.

We continue to think that economic data trump tapering and that the tapering timetable trumps forward guidance. It is most likely that a month from now the economic data flow will be viewed as much more significant than the forward guidance. This is eminently illustrated by the GBP and gilt reaction to UK forward guidance.

For the record, it looks as if expectations have converged to 1) September tapering USD10-15bn; 2) end by middle of 2014; 3) some downward revision to 2013-15 forecasts, but 2016 not to far from full employment; 4) a low trajectory of policy rate increase after mid 2015 (although they may view the projected start as a forward guidance tool); 5) some inflation threshold; 6) downward revision to the unemployment rate threshold possible but up in the air. We view 1) and 2) as more important than 3)-6) in determining how markets trade. If they hit expectations on 1) and 2), do not surprise too much on 3) or 4), but do nothing on 5) or 6) – that would be viewed as slightly hawkish.

In FX the stress point is still the weak end of EM, followed by AUD and NZD in G10, followed by JPY. The policy debate is about the pace and size of liquidity unwinding, and vulnerable currencies will bask in a dovish glow, and get hammered on perceived Fed hawkishness.




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