Diary of a Financier

Fed “tapering” early detection system: Regularly scheduled maintenance

In Economics, Idiosyncrasy on Tue 17 Dec 2013 at 23:30

{<Run program>:”Fed advanced warning checklist”}

{<Taper ON>=”ON“; “+“}

{<Taper OFF>=”OFF“; ““}

{<Commencing sequence>}

  1. Unemployment (Taper ON)
    • Headline unemployment rate (U3) (+): although it’s trending in the right direction, November’s latest report of a 7.0% unemployment rateUnemployment Rate vs Fed projections (November 2013) still exceeds the Fed’s explicit 6.5% target (which may get lowered to 6.0% for the long term), but it’s ahead of the Fed’s 7.1% YE13 schedule, plus some FOMC voting members have noted sufficient economic momentum to attain their goals over the intermediate term, during which they’ve said they’ll rely on ZIRP (not QE) to achieve that remaining progress
    • Labor force participation (): increased to 63% in November, which is far below the 66-67% long term average, but the new normal is largely attributable to population demographics–the very void in aggregate demand that QE has sought to fill
  2. Inflation (Taper OFF)
    • 5y5y TIPS forward inflation breakevens (): 5y5y at 2.42% 5y5y TIPS inflation breakeven vs SPXmeans long run inflation remains at the low end of its post-crisis range, but it’s right around that 2.5% sweet spot for the Fed and floating higher since June’s lows
    • Inflation (): November’s Headline CPI rose from 0.96 to 1.24%, with Core up from 1.68 to 1.72%, both far below the Fed’s 2-2.5% target
  3. Asset bubbles (Taper PUSH)
  4. Bank lending (Taper OFF)
    • Commercial & Industrial loans (): real (inflation adjusted) C&I loans to the real economy Commercial & Industrial bank loans outstanding- nominal (blue), real (red)are still very tepid compared to the insane spikes in Savings & Loan Crisis, Tech Bubble, and Great Recession
  5. Fiscal drag (Taper OFF)
    • Congress’ budget deal (): the recent spending agreement averted another fiscal standoff in January, but a debt ceiling debate still awaits with a deadline before March–an important hurdle when you consider that the Fed deferred a taper in September largely due to the uncertainty (i.e. known-unknown) around a government shutdown

{/<End>}

~~~~

Takeaway: #Taper OFF

As I noted earlier this week (I & II), the way this market has been behaving, my subtext herein could be: ‘How I learned to stop worrying and love the taper.’  I’ve gone down that road before:

“The conclusion must be that a QE tapering will trigger a proportionate de-risking only if the economy stalls. Then, capital would reverse its flow back down the pyramid towards risk-free assets. The de-risking aspect is generally accepted, but a simultaneous flight-to-safety bid for Treasuries… is not. The nice thing for long term, risk investors is that the Fed will re-up QE were the economy to founder.

With that in mind, let me provide some more context, as derived from the sentiment implied by capital markets.  Somewhat notably, Volatility ($VIX) has risen from an extreme low of 12 to a happy medium of 16 with little adverse resonance to equity prices.  Perhaps more importantly, both 10y Treasury yields ($TNX) around 3.85% 30y conforming mortgage rate- National averageand 30y mortgages at 4.3% are far above their 2012 lows and near September’s highs.

Like I said this past summer:

“Growth, inflation, and unemployment have not even come close to attaining the explicit goals set by the Fed… By dropping words-of-the-day, like ‘tapering,’ the Fed both tests the marketplace’s preparedness and talks down surging asset values.”

Given the context of today’s prevailing yield curve, I think the mere threat of an imminent taper has been a self-fulfilling prophecy [again], having encouraged interest rates to float gently higher via an overall bear steepening and risk assets to temper their optimism per VIX.

Accordingly, we cannot expect a crowding-out, thanks to the Fed’s “early warning system”–its best efforts to communicate transparent, quantitative triggers for a taper and promise gradual reductions thereafter. For example, Emerging Market central banks have been afforded the time to make measured, preemptive preparations to pare their USD/Treasury/Agency exposures.  In addition, pensions in aggregate are nearing fully-funded status may provide a future bid for bonds as they reallocate in 2014.

The point is: capital markets are prepared for a taper.

To borrow a phrase from the FOMC itself, ‘the benefits of QE still outweigh the risks.’  My base case remains a 1q14 taper–most likely in March. The downside scenario I foresee for the December meeting tomorrow is a small taper, reducing monthly LSAPs by $5-10B (from $85 to $80-75B), which is less than the $15B reduction being bandied about.

Gaming Fed psychology is a gamble like Russian Roulette. The point of this exercise is to establish a base case. From there, we handicap the odds of various outcomes and invest according to the probability-weighted expected return.

For now, I maintain my outlook for the intermediate and long terms, but the “Bullish” tag on this post pertains to the short term, for reasons discussed herein and previously.

–Romeo

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  1. […] Federal Reserve Open Market Committee statement & press conference (December 18, 2013) | Seeking Alpha Market Currents Fed announces start to QE tapering, reducing purchases from $85 to $75B/month ($5B less toward each Treasury & MBS LSAPs). As expected, FOMC extends ZIRP to 2016 (dovish “enhanced forward rate guidance”) and “anticipates that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6.5%, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal.” Updated FOMC 2014 projections: – PCE inflation 1.4-1.6% (narrowed fm 1.3-1.8% in September) – GDP growth 2.8-3.2% (narrowed fm 2.9-3.1%) – Unemployment rate 6.3-6.6% (narrowed fm 6.4-6.8%) [Ben Bernanke's last meeting.  At the close: $SPX +1.69%, $AGG -5bps, $FVX +2bps @ 1.515, $TNX +4bps @ 2.885, $GC_F -0.83%, $EEM +1.95%. See also: FOMC pregame] […]

  2. […] value there.  Second, while lending to the real economy (C&I loans) has been satisfiably tepid, it’s been displaced by junk credit issuance.  While I’d call this a Grey Swan that […]

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