Dollar: Has Fed Tapering Been Priced In?

Chicago (Dec 17)  The U.S. dollar traded higher against the commodity currencies but sold off against the Japanese Yen, euro and British pound. This diverging price action suggests that there is little conviction in the market about what the central bank will do this week. The uncertainty can also be seen in the conflicting performance of equities versus Treasuries as stocks rallied and bond yields both moved higher. While we believe that traders in the bond and FX markets have priced in tapering by the Fed this month or next, with 10 year Treasury yields off their September highs, we don’t believe that they have priced in the end of QE and more specifically the pace at which bond purchases will be halted next year. Originally the Fed had planned to begin reducing its monthly bond buying in the third quarter of 2013 and end the program by mid-2014. Its now December and its not even clear whether the central bank will slow purchases this month which means there is a good chance QE may not end until 2015. In all likelihood, policymakers themselves probably don’t know how quickly they want to wind down the program which is why there’s still room to upside for the dollar and U.S. yields when the Fed tapers.

Our base case scenario is for a small amount of tapering this month ($5 to $10 billion) followed by a noncommittal outlook for further reductions that would minimize the market’s reaction and give Janet Yellen the flexibility to design her own strategy for unwinding stimulus. Yet the decision will be a very close one with a reasonable number of economists looking for the Fed to taper in January or even March. For the Federal Reserve, the greatest motivation for December tapering is the strength of U.S. data. While the Empire State manufacturing index fell short of expectations, manufacturing activity turned positive in the NY region this month. Industrial production also grew at its fastest pace in a year in November while non-farm productivity rose 3% in the third quarter, the strongest pace of growth since September 2009. Since the last FOMC meeting, we have seen a significant recovery in consumer spending and the labor market but there are still pockets of weakness in other parts of the economy.

Putting ourselves into shoes of the central bank, we have compiled a table illustrating how economic data changed since the last FOMC announcement on October 30th. Non-farm payrolls have averaged 204k over the past 4 months and this strength drove the unemployment rate down to 7%. Retail sales also rebounded in November after contracting in September and according to the latest consumer sentiment survey, Americans are feeling more optimistic. Considering that it is only a matter of time before the Fed starts reducing its monthly bond buys, it may be strategically sensible to begin tapering this month so they can spread the reductions over a longer period of time. However as indicated in the table below, inflation remains very low, giving policymakers the option to wait because inflation is not a major risk. The housing market has also been mixed but more importantly, stronger manufacturing activity is offset by slower growth in the service sector. U.S. yields have increased significantly over the past 7 weeks and by tapering, the central bank risks driving 10-year yields to 3%. As you can see, strong arguments can be made for tapering in December or January, which is why this month’s FOMC announcement could trigger unusually large volatility in currencies.