So having gotten the taper view wrong like most people, I am revisiting exactly how that happened. I think the surprise is encapsulated by the fact that I (and possibly the market) understood the forward guidance idea as meaning that the Fed would verbally intervene, or “guide,” rates when they thought that yields were too high or low. After all, doesn’t “guidance” imply something more regular than just saying things at meetings? And since overnight rates are at zero, which leaves intermediate term yields as the main central bank policy lever, doesn’t it make sense that the Fed would take a more active role in “guiding” those yields? In July, Bernanke’s dovish comments and verbal jawboning seemed to confirm this interpretation. But as the data continued to improve later in July and August, yields moved higher, but the FOMC core was silent. This meant that, if you thought the Fed would be verbally “guiding” rates, their LACK of communication as yields moved higher was itself a tacit affirmation of a faster pace of tightening.
Anyway… As we know now, “forward guidance” doesn’t imply that the Fed will attempt to keep yields in a corridor between meetings at all. They will state their message at meetings, as they did before, and maybe clarify it once, and that’s it, regardless of where market yields are.
What is interesting to me is that many market participants seem to be mis-interpreting the Fed again. I have read multiple reports today with headlines along the lines of “Message from Fed: Listen to the data.” But I think that is the wrong take away and that really isn’t where the market went wrong. Data since the June FOMC meeting has substantially exceeded analyst expectations on average. Bernanke said in his opening remarks “At the meeting concluded earlier today, the sense of the Committee was that the broad contours of the medium-term economic outlook… were close to the views it held in June.” (pgs 4-5) In other words, the data did NOT disappoint the FOMC, which means that it was NOT the reason the Fed acted as it did. Rather, the catalyst seems to have been concerns about the effects of higher mortgage rates and the upcoming budget battle. Bernanke said “the Committee has some concern that the rapid tightening of financial conditions in recent months could have the effect of slowing growth, as I noted earlier, a concern that would be exacerbated if conditions tightened further. Finally, the extent of the effects of restrictive fiscal policies remains unclear, and upcoming fiscal debates may involve additional risks to financial markets and to the broader economy.” The take away, for me at least, is that barring a slowdown, the start of tapering is dependent on two factors that will dissipate over time. The tightening in financial conditions is a function of the SPEED of the move in yields, so that factor will ease on its own if yields stay stable. And the government shutdown, should it happen, will eventually be resolved in the time, one way or another.
With Eurodollar futures almost exactly pricing in the FOMC’s median interest rate projections, yields look fair. And with the budget battle unlikely to be resolved before the end of October, that puts December as the likely first date of tapering, barring the downside risks emanating from the government shutdown. In my estimation, the full effects from the higher yields may not be apparent until 1Q next year. It is also worth noting that both risks are to the downside… and expectations for the data have been revised higher already.
- UK Retail Sales declined to 2.3% YoY vs 3.2% exp and 3.1% prev
- US Initial Jobless Claims rose to 309k vs 330k exp and 292k prev but data completeness problems persist.
- Philly Fed jumped to 22.3 vs 10.3 exp and 9.3 prev
- Existing Home Sales rose to 5.48mm in Aug vs 5.25 exp and 5.39 prev
- Nikkei reported that Abe has decided to raise the consumption tax in Apr as planned to 8%. Abe plans to announce his decision on Oct 1. As part of a tax deal, corporate tax rates will be lowered and the special reconstruction tax will be scrapped.
- Prime Minister Shinzo Abe instructed his finance minister on Wednesday to include a two-stage lowering of corporate taxes in economic stimulus measures that would kick in if the consumption tax is hiked in April as planned. "A drastic corporate tax cut is necessary," Abe told the minister, Taro Aso. The first part of Abe’s plan is to end a special reconstruction tax related to the March 2011 disaster one year earlier than planned. This 10% add-on to the corporate tax is currently slated for termination at the end of fiscal 2014. The prime minister also instructed Aso to set a clear medium- to long-term plan for bringing Japan’s effective corporate tax rate down to a level on a par with other major nations in fiscal 2015 or afterward. Nikkei
- Fri: RBI, Canada CPI
- Mon: China Markit Flash Mfg PMI, EU PMI, Chicago Fed National Activity Index, Market US Preliminary PMI
- Tue: German IFO, Canada Retail Sales, US Home Price Index, US Consumer Confidence
- Wed: Italy Consumer Confidence, US Durable Goods Orders, New Home Sales
- Thu: France Consumer Confidence, EU Money Supply, US Jobless Claims, Pending Home Sales, Japan CPI