The billion dollar question to which there are many solutions, ideas and opinions is, “ What are the U.S. going to do and by how much as regards to Tapering the Quantitative Easing”? What we do know for sure is that at 7pm UK time, there will be an announcement from the Fed on rate policy and asset purchases. This will be followed by a press conference and a Q&A session at 19.30. In this part, the Fed are likely to offer more guidance on the tapering path that will be adopted and importantly, will give us their updated view on the US economy for the period to 2016, along with their view on where rates might be.
Given that the Fed’s possible tapering has been the single biggest driver of market risk since it was first discussed on May 22nd, tonight’s announcement and press conference has rarely been more significant.
As far as OCM is concerned this is part of the reason why we are in cash and waiting to see which direction the market takes before reinvesting (noting it was predominantly the conflict in Syria which led us to this decision). We are therefore waiting to see what direction the market takes either tomorrow or after the weekend.
Background and Analysis
On May 22nd, the 10 year treasury note (equivalent of UK Gilt) was yielding 2.04%. Today it yields nearly 2.85%, having briefly exceeded 3% earlier in the month. In fixed income terms this is quite a big move in a short period of time and clearly the market has now priced in the inevitability of Fed tapering starting this month. However, while most forecasters are calling for tapering to start tonight, there are still one or two who think it will not happen until later this year, and there is plenty of disagreement as to how much will be done and over what time frame. In fact, many remain convinced that by this time next year, the Fed will still be increasing its balance sheet.
Our own view is that the Fed continues to have a very good handle on the economy and has been broadly right in its assessment since tapering talk began. At that point, Bernanke told markets that tapering would start later in the year and would most likely conclude in mid-2014 if the economic data was consistent with their view as they saw it. Bernanke hinted that the tapering could start after Labor Day, and this is the first FOMC meeting post the Labor Day holiday. We therefore see no reason why the Fed would not start tapering tonight. Additionally, there is now enough scepticism amongst the FOMC members about the effectiveness of the asset purchases that a consensus should be relatively easy to reach.
Fundamentally, the economy is in a very different place now from where it was when the Fed began its $3 trillion balance sheet expansion almost 5 years ago. Whist it was certainly necessary then, right now it can be argued that they are just fuelling asset prices and making the eventual exit more troublesome. The Fed will also have been watching the market reaction very closely since May and we don’t think they will be unhappy with where yields have moved to, and these are in line with our own projections. By not tapering tonight they would push yields in the opposite direction to the way that they will need to be going over the coming years. Our conclusion that the Fed will taper by at least $10 to $15bn which is against the majority, who according to Bloomberg expect only a small reduction of say $5bn.
We are therefore expecting volatility, depending on what the Fed has to say in the press conference and Q&A thereafter. We expect the message to be very similar to the one that they sent in May; confirming that they are on track to end tapering in mid-2014, but are ready to act on any softness in the economy if it arises, and that purchases can go up as well as down. Bernanke will be seeking to make his address in the most market pacifying way possible. This is because we think the Fed will want a slow, gradual rise in the rate curve and will be wary of causing any spikes that could result in a drop in confidence. By tomorrow, the market will be forming a new view on the next taper and we will need the data flow to once again support the decision. In the past the Fed has moved in regular small steps when adjusting rate policy so we might just find ourselves in a position by year end with several tapers behind us.
We think it is the overall sentiment about when tapering will cease combined with how quickly the markets will react to it. Therefore, whichever way we look at it we expect it to be negative.
Our conclusion is that we will decide on our next asset allocation decision tonight and tomorrow based on the markets reaction to the press release and Q&A. If the reaction is positive we will reallocate and if negative we will wait and allocate at the point when we see investor value.
And Finally on Syria
As regards to Syria, the diplomatic moves seem to have averted the dooms day scenario that we were planning for by moving to cash. However, as we note above, Syria was not the only reason to be defensive and protect capital values but it was our worst case scenario. As a result of our actions we will look for potential to buy low in to the market and add value to our client portfolios. To date the market has risen slightly since we made the conviction led move so we have left some capital on the table, but not much, and we feel if the Fed do as expected that Fat will be wiped out in the next few days giving value to our decision.