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The USD Will Pursue its Rally as Investors Underestimate the Pace with which the Fed Will Tighten its Policy

According to the Bloomberg, on January 30, Federal Reserve Bank of St. Louis President James Bullard said investors are wrong to expect the Fed to postpone an interest-rate increase beyond midyear, with the U.S. economy leading global growth and unemployment dropping and noted that:

 

The market has a more dovish view of what the Fed is going to do than the Fed itself…
… Markets should take it at face value from the Fed’s rate projections

 

In this context, I decided to take a look at both Fed fund futures and latest FOMC median forecasts (December) and the fact is that the gap between investor’s expectations and Fed guidance is simply HUGE. As a matter of fact, Fed officials expect the benchmark funds rate rise to 1.125% by the end of 2015 while investors are only betting on 0.410%.

 

 

Of course, Fed’s forecasts seem to be too agressive as they imply four rate hikes for 2015 in a context of 1) CPI’s weakness, 2) global slowdown and 3) geopolitical tensions, but a liftoff by midyear remains the base case scenario. Separately, according to Fed funds futures, investors see only a 15% chance that the Fed will raise its benchmark rate in June.

 

As a consequence, this situation implies that there is still a huge potential of appreciation concerning the USD especially as:

1) ECB will implement QE next month.

2) SNB has an unofficial corridor of CHF1.05-CHF1.10 against €.

3) BOJ will keep on implementing an accommodative monetary policy.

The FOMC Minutes Confirm That The Probability of “Tapering” In 2013 Is Less Than 50%

- Christophe Barraud

 

Last night, I read the FOMC Minutes and I didn’t see any change regarding the Fed Communication which suggests that “tapering” will occur soon (in 2013). This morning, this opinion was not shared by the financial press which underlines that some Fed members would have preferred to taper in September and that the status quo could potentially undermine the Fed’s credibility.

 

The fact is that contrary to many economists and journalists, I’m able to make the difference between arguments from voters (who backed “no taper” at 9/1 in September) and non-voters (who are far more “hawkish”)

 

We could isolate some excerpts on asset purchases from the FOMC Minutes:

 

In their discussion of the path for monetary policy, participants debated the advantages and disadvantages of reducing the pace of the Committee’s asset purchases at this meeting, focusing importantly on whether the conditions presented to the public in June for reducing the pace of asset purchases had yet been met. In general, those who preferred to maintain for now the pace of purchases viewed incoming data as having been on the disappointing side and, despite clear improvements in labor market conditions since the purchase program’s inception in September 2012, were not yet adequately confident of continued progress. Many of these participants had revised down their forecasts for economic activity or pointed to near-term risks and uncertainties. For example, questions were raised about the effects on the housing sector and on the broader economy of the tightening in financial conditions in recent months, as well as about the considerable risks surrounding fiscal policy. Moreover, the announcement of a reduction in asset purchases at this meeting might trigger an additional, unwarranted tightening of financial conditions, perhaps because markets would read such an announcement as signaling the Committee’s willingness, notwithstanding mixed recent data, to take an initial step toward exit from its highly accommodative policy. As a result of such concerns, a number of participants thought that risk-management considerations called for a cautious approach and that, in light of the ambiguous cast of recent readings on the economy, it would be prudent to await further evidence of progress before reducing the pace of asset purchases. Consistent with the framework discussed by the Chairman during the June press conference, asset purchases were contingent on the Committee’s ongoing assessment of the economic outlook and were not on a preset course; this approach implied a need to adapt and to adjust asset purchases in response to changes in economic conditions in order to preserve the Committee’s credibility.

 

This excerpt is absolutely coherent with last voters’ speeches (excluding Esther George). As an example, I selected some headlines from my archives:

 

***On September 18 – Fed Chairman Bernanke (dove, FOMC voter) / Economic data does not yet warrant a reduction in asset purchases; To await further evidence of recovery.
- Bernanke commented that the Fed is concerned about economy and wanted to observe the effects of higher interest rates before making adjustments to QE.
- Primary reasons for central fed fund rate forecast being at 2% for 2016 unusually low when other economic indicators are expected to be more normalized, are current headwinds that could still persist including the slow recovery in housing sector, and continued fiscal drag.

 

***On September 20 – Fed’s Bullard (moderate, FOMC voter) / The economy is not that fragile, but there has been some weaker data.
- Wants to see a recovery in inflation before adjusting stimulus program, inflation is expected to rise over the upcoming quarters.

 

***On September 23 – Fed’s Dudley (dove, FOMC voter) / Labor market improvements have likely been overstated.
- Fiscal drag and current market interest rates are a drag on growth.
- Fiscal uncertainty is one issue impacting the schedule for exiting QE, along with market interest rates and less good data.

 

***On September 26 – Fed’s Stein (dove, FOMC voter) / Sept decision against taper was ‘close’.

 

***On September 27 – Fed’s Evans (dove, FOMC voter) / Need more confidence in GDP to taper.

 

***On October 2 – Fed’s Rosengren (dove, FOMC voter) / Strongly backed FOMC’s decision not to taper QE at the Sept meeting.
- Fed should only remove accommodation when employment and GDP recover.
- Must be prepared to offer more accommodation if needed.

 

Other voters (excluding Esther George) have not made any speeches concerning economic activity and QE following the September FOMC meeting. However, everybody knows that Janet Yellen and Jerome Powell are very “dovish” and therefore they strongly supported the decision to let the asset purchase program unchanged in September.

 

At the opposite, I can’t deny that some members urge to reduce the asset purchase program as soon as possible:

 

The participants who spoke in favor of moderating the pace of securities purchases at this meeting also cited the incoming data, but viewed those data as broadly consistent with the Committee’s outlook for the labor market at the time of the June FOMC meeting when the contingent expectation that the pace of asset purchases would be reduced later in the year was first presented to the public. Moreover, they highlighted what they saw as meaningful cumulative progress in labor market conditions since the purchase program began. Those participants generally were satisfied that investors had come to understand the data-dependent nature of the Committee’s thinking about asset purchases, and, because they judged that the conditions laid out in June had been met, they believed that the credibility of the Committee would best be served by announcing a downward adjustment in asset purchases at this meeting. With the markets apparently viewing a cut in purchases as the most likely outcome, it was noted that the postponement of such an announcement to later in the year or beyond could have significant implications for the effectiveness of Committee communications. In particular, concerns were expressed that a delay could potentially undermine the credibility or predictability of monetary policy by, for example, increasing uncertainty about the Committee’s reaction function and about its commitment to the forward guidance for the federal funds rate, with the result of an increase in volatility in financial markets. Moreover, maintaining the pace of purchases could be perceived as a sign that the FOMC had turned more pessimistic about the economic outlook. Finally, it was noted that if the Committee did not pare back its purchases in these circumstances, it might be difficult to explain a cut in coming months, absent clearly stronger data on the economy and a swift resolution of federal fiscal uncertainties. Most of the participants leaning toward a downward adjustment in the pace of asset purchases also indicated that they favored a relatively small reduction to signal the Committee’s intention to proceed cautiously.

 

These findings were only reported by Esther George and other Fed members who are non-voters as we can see below:

 

***On September 26 – Fed’s Lacker (hawk, FOMC non-voter) / Would be difficult to start taper in Oct without losing face (but its could be done in principle based on data), but don’t see any reason why the taper can’t start in Dec.

 

***On September 27 – Fed’s George (hawk, FOMC voter) / Decision not to taper bond buying could threaten credibility of future Policy.
- Disappointed by decision not to taper, US economic fundamentals have improved substantially.
- Delaying action could lead market to wrongly judge that Fed has become more pessimistic on economic outlook.
- Fed should lay out clear plan about taper start time.

 

***On September 30 – Fed’s Plosser (hawk, FOMC non-voter) / FOMC undercut the credibility of its own forward guidance, September’s non-action calls the unemployment thresholds into doubt.

 

***On October 3 – Fed’s Fisher (hawk, FOMC non-voter) / Fed is contributing to economic uncertainties.

 

***On October 4 – Fed’s Lacker (hawk, FOMC non-voter) / Would have voted to taper even if he had known the US was headed for a two-week govt shutdown.
– Labor market conditions have improved substantially since the Fed began QE.

 

***On October 8 – Fed’s Plosser (hawk, FOMC non-voter) / Time has come to expeditously phase out the QE program; economy is expanding at 2.5% this year, next year should grow at 3%.

 

To sum up, for me, it’s clear that voters are more cautious than non-voters concerning both employment, growth and inflation. In the meantime, the “government shutdown” has a negative impact on Q4 GDP so that growth forecasts set in September should be at risk. Moreover, the slowing of growth means less inflationary pressures in a context where we are far below the 2% target. Finally, the latest employment figures (ADP, employment component of ISM services, Intuit Survey, Challenger Job Cuts and now Initial claims) suggest a weaker trend. As a consequence, “Octaper” is very unlikely.

 

Now, if we focus on December, I think that the probability of “tapering” is less than 50% for different reasons:
 
1/ The Employment report for October and November will be affected by the “government shutdown” an could lead to a wrong interpretation.
2/ Q3 and Q4 GDP should be weak so that Fed could revise downward its growth forecast for 2013 and maybe 2014.
3/ Inflation will not bounce back immediatly.
4/ Even if Democrats and Republicans are able to find a temporary compromise on the continuing resolution, another “government shutdown” is possible at the end of the year. Indeed, it will be very difficult for politicians to define the amount of new budget cuts and their affectations (civil – defense) for 2014.
 

Finally, I would like to note that the only error of the Fed concerning its communication is to let speaking non-voters too often so that it could lead investors to make mistakes.

Federal Reserve Gave Six Signals that “Tapering” Will Not Start at its Next Meeting

On Wednesday, the Federal Reserve gave six signals that “tapering” will not start at its next meeting in September:

 

1/ It downgraded its view of economic activity, calling the pace of growth “modest” rather than “moderate”. The fact is that GDP publication shows that growth slowed significantly in H1 2013. Moreover, the Fed’s forecast for 2013, which was [2.3%-2.6%] in June, could not be achieved. As an example, the GDP should grow by 4% (QoQ annualized) in Q3 and Q4 to reach 2.6% in 2013. As a consequence, in September, the Fed committee will be obliged to revise sharply its growth estimate for 2013 and also the next coming years.

 

2/ The Federal Reserve noted that mortgage rates had risen, implicitly flagging this as a drag to the housing recovery which was one of the main driver of US growth last quarters.

 

3/ Inflation weakness became a concern of most Fed members. A subject that apparently secured the vote of St. Louis Federal Reserve Bank President James Bullard, who dissented in June over worries about deflation.

 

4/ Fed members did not give any guidelines about how the committee might adjust its purchases in response to economic developments. I expect that Fed committee will detail clearly its strategy before “tapering” because it wants to avoid any tensions on the financial market in a context where fiscal uncertainty remains.

 

5/ Once again, Fed members underlined that fiscal policy is restraining economic growth. I believe that lawmakers will not find compromise on the “continuing resolution” and 2014 budget until the end of September. Therefore, as I said before, the Federal Reserve will not create more uncertainty.

 

6/ Despite better labor market conditions, the Federal Reserve noted that “unemployment rate remains elevated”.

 

FOMC Statement:

 

Information received since the Federal Open Market Committee met in May suggests that economic activity has been expanding at a moderate pace. Labor market conditions have shown further improvement in recent months, on balance, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy is restraining economic growth. Partly reflecting transitory influences, inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.
 
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic growth will proceed at a moderate pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate. The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished since the fall. The Committee also anticipates that inflation over the medium term likely will run at or below its 2 percent objective.
 
To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.
 
The Committee will closely monitor incoming information on economic and financial developments in coming months. The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes. In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.
 
To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.
 
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Jerome H. Powell; Sarah Bloom Raskin; Eric S. Rosengren; Jeremy C. Stein; Daniel K. Tarullo; and Janet L. Yellen. Voting against the action was James Bullard, who believed that the Committee should signal more strongly its willingness to defend its inflation goal in light of recent low inflation readings, and Esther L. George, who was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations.

Fed’s Bullard: Reiterates the Fed May Need to Increase QE if Inflation Slows

Federal Reserve Bank of St. Louis President James Bullard dissented from the FOMC’s June 19 decision to maintain the pace of asset purchases saying the central bank may need to increase monthly asset purchases above the current $85 billion pace if inflation slows further below its 2 percent goal.

 

In an unusual move, Bullard published a press release on why he dissented:

 

Federal Reserve Bank of St. Louis President James Bullard dissented with the Federal Open Market Committee decision announced on June 19, 2013. In his view, the Committee should have more strongly signaled its willingness to defend its inflation target of 2 percent in light of recent low inflation readings. Inflation in the U.S. has surprised on the downside during 2013. Measured as the percent change from one year earlier, the personal consumption expenditures (PCE) headline inflation rate is running below 1 percent, and the PCE core inflation rate is close to 1 percent. President Bullard believes that to maintain credibility, the Committee must defend its inflation target when inflation is below target as well as when it is above target.

 

President Bullard also felt that the Committee’s decision to authorize the Chairman to lay out a more elaborate plan for reducing the pace of asset purchases was inappropriately timed. The Committee was, through the Summary of Economic Projections process, marking down its assessment of both real GDP growth and inflation for 2013, and yet simultaneously announcing that less accommodative policy may be in store. President Bullard felt that a more prudent approach would be to wait for more tangible signs that the economy was strengthening and that inflation was on a path to return toward target before making such an announcement.

 

In addition, President Bullard felt that the Committee’s decision to authorize the Chairman to make an announcement of an approximate timeline for reducing the pace of asset purchases to zero was a step away from state-contingent monetary policy. President Bullard feels strongly that state-contingent monetary policy is best central bank practice, with clear support both from academic theory and from central bank experience over the last several decades. Policy actions should be undertaken to meet policy objectives, not calendar objectives.

 

While President Bullard found much to disagree with in this decision, he does feel that the Committee can conduct an appropriate and effective monetary policy going forward, and he looks forward to working with his colleagues to achieve this outcome.

 

After the FOMC, a Bloomberg News survey showed that according to 44 percent of economists, a plurality, the bond buying will be cut by $20 billion at the Sept. 17-18 policy meeting. In my opinion, economists should give more credit to Bullard’s analysis and should not expect any tapering before December. The fact is that inflation will stay very low in the short term because:

 

1/ Global growth will not recover due to China’s slowdown. As a consequence, energy prices will not rebound.

2/ US growth will stay limited around 2% until fiscal issues will be solved (maybe at the end of Q3).

3/ In these conditions, employment conditions will improve slightly and wages’ increase will be contained.

4/ Real estate prices and rents will be affected by an increase in inventory.