Odds that Fed will delay tapering rise as US economy stumbles
September tapering by the US Fed, which until recently markets took as given, is looking less certain as downside risk factors for winding down the central bank’s $85 billion-a-month stimulus programme continue to mount.
The prospects for tapering are being buffeted by risks ranging from disappointing economic data on jobs and interest rate sensitive sectors, such as housing, and the deadlock in Washington over the debt ceiling, to worries over possible military action against Syria.
The Fed will also have to weigh warnings from the G20 and the IMF to leading academics, that tapering will worsen the rout in emerging markets (EMs).
Second-quarter GDP growth has been revised up to 2.5%, but the current quarter is looking much weaker and is likely to come in at around 1.7%, or lower.
Capital goods spending and housing are showing signs of weakness. New home sales and mortgage applications are down. That might have something to do with surging mortgage costs as rates have backed up on higher treasury yields. The rate for a 30-year fixed rate is nudging 4.6%, up from 3.6% in July and 3.35% in May.
On the plus side of the ledger, unemployment and inflation are moving in the right direction, while the industrial sector also appears to be faring better. The purchasing managers’ manufacturing index bucked a forecast fall in August, instead rising slightly even as government spending cuts begin to bite.
Markets have fixated on September, but the minutes of the Federal Open Market Committee’s (FOMC) July meeting are ambiguous, showing only that members agreed they were minded to begin tapering at one of the next three meetings. That could mean September, but it could equally be October or December.
With it looking more likely the dark clouds that are building will converge around the time the FOMC meets, the voting members could very well err on the side of caution and postpone any taper.
“A possible geo-political event in the Middle East, the budget stalemate on cutting the deficit or raising the debt ceiling, and how fear of tapering is affecting interest rate sensitive areas of the economy mean it could very well be that it is deferred until perhaps December,” says Investment Quorum’s chief investment officer Peter Lowman.
“There are no guarantees it will start. The economic data is still quite difficult to analyze because we get certain months when things are looking better and we end up with a fast ball, like last month, showing housing slowing.”
Lowman says that with the stronger dollar making it harder for investors to withstand the stresses of what EM economies now look like, there has been a move of capital flows back into the US market that have pushed the stock market higher.
“If we now go to the situation where tapering doesn’t happen until the end of the year, or even the beginning of next year, there could be another swing back and we might start seeing investors taking money out of the US market and back into some of the areas of the world that look better value such as Europe and EM,” he says.
“Over the next two to four weeks we could see a change of consensus. In May and June we saw a big flood of money going into global equities, with equities being bought in favour of bonds and cash. But we’ve had a sudden reversal in August with a turnaround in risk aversion and we could see a change of sentiment toward tapering when the Fed meets.”
Optimism that the economy is accelerating in the second half is being eroded by tame inflation and lacklustre spending by consumers, who account for more than two-thirds of the economy. Consumers are worried about the higher costs of borrowing, which in turn are being driven by expectations of Fed tapering.
July spending was up 0.1% – flat when adjusted for inflation – and weak consumer sentiment means it is likely to stay subdued. Inflation in the year to July was 1.4%, well below the Fed’s 2% target, and taking out food and energy, it actually slowed from June.
Capital Economics’ chief markets economist John Higgins says there has been a hardening of the view on tapering in recent weeks that has impacted interest rate expectations.
“Providing the Fed interprets these rising treasury yields as consistent with the gradual improvement in the economy, it’s not going to act to restrain that,” he says. “Unless the economy takes a material turn for the worse and the Fed feels that the upward pressure on bond yields was not justified, then I can’t see it postponing its plans to taper.
“The vast majority of market participants now do expect it, if not in a couple of weeks’ time, before the end of the year. That re-assessment means some investors have had a hard time disentangling that outlook for the Fed’s asset purchases from the outlook for interest rates.
He adds: “They seem to be thinking that just because the Fed is on the cusp of scaling back the amount it’s going to buy that it’s therefore more likely to be raising interest rates anytime soon.
“The market has got a little bit ahead of itself in expecting interest rates to be rising over the next couple of years, which now seems to be what’s being discounted, judging by the rise in short-term interest rate expectations from the overnight index swap curve.”
Higgins says a split in the FOMC over timing means there could be a compromise with a smaller-than-expected reduction of about $10 billion, rather than $20 billion.
Treasuries saw a sharp reversal of capital flows in June with net outflows of $40.8 billion as EMs sold treasury holdings to support their own under-pressure currencies.
That is likely to have continued over the summer as more EM currencies have weakened, lessening the imperative for exporting economies’ central banks to hold treasuries. Fed figures for the week ending August 28 show central banks’ holdings fell by $5.06 billion to $2.92 trillion, revisiting the low reached in June.
“We’ve got a strange situation where the market is discounting tapering, but the evidence doesn’t seem to support a move now so they could deliver a token amount, reducing purchases by say $5 billion instead of $10 billion,” says Frances Hudson, global thematic strategist at Standard Life.
“The Fed would still be pumping in $75 billion a month but it’s the psychology of whether saying the economy is strong enough to taper is enough to counterbalance the ‘we’re taking away your free money’.
“They’ve given themselves enough wriggle room to postpone. It’s not what bond markets are anticipating but the Fed could just say it’s waiting for more confirmation on the sustainability of the recovery.
She concludes: “Tightening in terms of the official policy rate may be a long way away but liquidity into the market is the concern and that liquidity, as supplied by central banks, is falling on a global basis.
“The long end on bond yields is telling us that the Fed funds rate is not really relevant because it’s not functional in terms of rationing credit in the market. Until the policy rate starts moving, the Fed is kind of out the equation in terms of what happens in the broader economy.”