Monday, May 13, 2013

Commentary: Talks of Tapering Probably a False Alarm

The Fed Rumors continue to swirl that the Federal Reserve may 'taper off' its bond purchase program before the end of the year. The market response has been soggy equity markets, a rally in Treasuries, and broad dollar strength. Specifically, the Fed is concerned that communicating the exact timing and nature of its implementation of its exit strategy may cause chaos in the Treasuries and MBS markets with participants rushing to front end any policy action by shorting these securities. This may make the Fed's promise to continue its open ended commitment to purchase 85 billion in Treasury and MBS, so long as unemployment remains over 6.5 percent and inflation under 3 percent, a tricky proposition. Should the BLS report high inflation or unemployment outside the Fed's stated targets, traders may begin to short Treasuries and MBS in anticipation of the winding down of the Fed's asset purchase program. 

One fact must be considered however. Even if the Fed decides to 'taper off' its purchases, such a move not represent a tightening of policy. Rather, it would only represent a reduction of the pace at which further liquidity is injected into the financial system. Hence, actual trades by the central bank won't come into play. Instead, the market will only have to rediscount the changed pace of liquidity injection. In other words, assuming that the price of the USD, stocks, bonds, or other securities already factors in the factor that the Fed will pump in 85 billion per month of fresh liquidity, how would actors re-adjust price expectations if the Fed cut its purchases by some modest figure, say 15 billion? 

I'm not sure, but I doubt a modest reduction in new liquidity being pumped into the economy will crush risk sentiment and result in falling stock prices and a resurgent USD. True, the USD may strengthen on the news, but knowing the Fed, any winding down of the Fed's QE program will be accompanied by good economic indicators which means that the broader economy can support higher rates. (Or rather, less accomadation, since rates are unlikely to rise until the Fed raises the rate paid on excess reserves or sells securities) In other words, expectations of higher returns will make risk takers willing to pay higher rates to obtain financing. For this reason, especially with rates near their zero bound, the unwinding of the Fed's balance sheet will probably be accompanied by increased loan demand, spurred on by a growing economy, and in spite of rising rates. A resumption of robust credit growth will be highly supportive of stock prices, housing prices, domestic consumption, and growth. 

 On FX, credit growth will affect the USD in two ways. Stronger growth in the US vis-a-vis other major economies will be highly USD supportive, even if this is obtained largely via increased leverage. However, as we saw in the 2000s, credit growth can also be USD negative, especially if US or foreign firms borrow in USD but invest abroad. However, this scenario seems unlikely to repeat itself. US firms will shift their focus towards North America, especially if the United States continues to lead the global recovery among advanced economies. Furthermore, firms abroad, especially in Europe, will be able to obtain cheaper financing in Euros, especially since it remains clear that the ECB has left the door for further easing wide open. True, European capital markets don't have the depth or liquidity of the US, but this will only be a factor for very small firms. Finally, we are seeing some US firms issuing Euro denominated bonds to obtain lower rates. DirectTV floated a five hundred million dollar eurobond today. In sum, whether the special place the US has in the world economy makes the USD the financing currency of choice as the credit cycle ramps up, despite higher rates than EUR or JPY, will be the key driver of the dollar in coming years.

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