No Taper No Dollar

The Fed told us many times “tapering is not tightening”. By that same logic, yesterday’s “not to tapering” is “no easing”.  But the resulting market response certainly felt like an easing. And it will continue to do so for a while.

The Fed decision to maintain $85 bn in monthly asset purchases is the latest manifestation of fiscal policy interfering with the central bank’s adjustment of monetary policy. The risk of a government shutdown next month and the resulting failure to raise the debt limit could exacerbate the nascent recovery if $10bn or $15 bn were removed.

Today’s release of US August existing home sales hitting 5-year highs and the Philly Fed index at 2-year highs appear a valuable set of evidence in markets’ data watch, but it is the labour market data, which command supremacy for the Fed.

From Draghi’s September to Bernanke’s September

In September 2012, ECB president Mario Draghi fired up global markets by unveiling the details of the Outright Monetary Transactions, which signalled unlimited ECB purchases of Eurozone bonds in the event that a struggling member nation signed up for assistance. Yesterday, the Federal Reserve had the same effect on markets by wrong footing most seasoned Fed watchers and bond traders after stating that not only the economic improvement  of the past 9 months was not good enough, but also that no chanced will be taken while the the US government’s borrowing capacity remains in doubt.

As in last autumn, markets are likely to cheer on prolonged easing from the US and stabilizing data in Europe. It also seems a return to the risk-on/risk-off set up, whereby rising global equities advance at the expense of the US dollar and the yen. $1.63 GBPUSD, $1.3700 EURUSD and 0.9700 AUDUSD are all anticipated for this month.

What if Yields Rose Again?

Here’s the Fed’s upcoming trick, likely to be added into the forward guidance. So far, the guidance has primarily focused on a threshold for the unemployment rate, but yesterday’s comments from Bernanke suggested setting an “inflation floor” as a “sensible modification to the guidance”. If attained, this could be a successful means of slowing down rising yields as long as falling unemployment is not accompanied by a recovery in inflation. The Fed’s preferred inflation figure, core  PCE price index, is at 2 ½ year low of 1.2%. Further declines nearing 1.1% could render the inflation forward guidance to become a carte blanche for further awaiting that 6.5% unemployment rate without fretting about the need for higher interest rates.

Remember the 7% Statement from Bernanke

One of the main reasons we had expected tapering would begin in yesterday’s FOMC announcement was Bernanke’s statement made in June: “In this scenario when asset purchases ultimately come to an end the unemployment rate would likely be in the vicinity of 7%”.

Today, unemployment is at 7.3% and asset purchases remain intact. What if the unemployment rate drops to 7.0% earlier than the Fed anticipates? After all, the unemployment rate fell from 8.2% in July 2012 to 7.8% in September 2012. And it fell from 7.9% in January 2013 to 7.6% in March 2013—also within 2 months. The possibility for unemployment to reach 7.0% before year-end from August’s 7.3% is considerable. And if that occurred without an adequate increase in the labour participation rate, then the Fed’s credibility and quality of labour data will come under fire.

Regarding the 6.5% unemployment threshold for raising rates, Bernanke reiterated that the jobless rate may have to fall well below that level before tightening. He said most of the decline in the unemployment rate was “due to job creation, not the downward trend in the labor force participation rate”. He did call “the unemployment rate the single best indicator of the labor market” but added it is not fully representative of labour market activity.