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Important disclosures can be found in the Disclosures AppendixAll rights reserved. Standard Chartered Bank 2013 research.standardchartered.com
Thomas Costerg +1 212 667 [email protected]
Daniel Tenengauzer+1 645 845 [email protected]
John Davies, +44 20 7885 7640
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Sophii Weng +1 212 667 [email protected]
| Global Research | 15 August 2013
United States Tapering untangled
We expect QE to be tapered in September by USD 10bn, end in Q2-14; we see the first rate hike in Q3-15
Ourtaperingscenario depends on economic data, the Feds rhetoric, and the impact of the wealth effect
The risks to our call include weaker-than-expected growth and a shift in tone, with a new FOMC next year
Summary
We keep our tapering view unchanged after recent data and Federal Reserve (Fed)
bankers speeches. We still expect a reduction in the Feds quantitative easing (QE)
programme on 18 September, after the two-day Federal Open Market Committee
(FOMC) meeting. But the signals from both recent data and the Feds rhetoric are not
clear-cut: this is still a close call. We are changing our view about what we believe
the Fed will cut first. Rather than being evenly split between mortgage-backed
securities (MBS) and US Treasuries (USTs), we now think the first cut, which we
forecast to be USD 10bn, will be USTs only. We see subsequent cuts of
USD 10-15bn at each meeting, including meetings without press conferences. We
think the Fed will start cutting MBS in January 2014, and the QE programme looks
set to end by mid-2014, when the unemployment rate drops below 7%, in line with
Chairman Bernankes guidance in June. But the 7% threshold is soft; key is that
tapering will be gradual.
Once tapering has started, the focus will be on the next step of the Feds QE exit
plan. We expect the Fed to continue reinvesting maturing securities in the QE
programme for several quarters, something it is l ikely to increasingly emphasise in itscommunication. With further improvement in the economy, especially narrower output
and labour-market gaps, we see the Fed stopping these reinvestments from
Q1-2015, six months before the first rate hike, which we still forecast by Q3-2015. In
June, the Fed indicated that it will keep its MBS portfolio to maturity; we think it will
confirm this when it updates its exit strategy principles.
In this piece, we lay out the three factors which determine our tapering call: the data,
the Feds rhetoric, and the wealth effect. Upcoming data releases regarding the
labour market, private consumption and the housing market will be central. The Fed
would like to see more signs that the economy is withstanding the current fiscal
consolidation, and that the fiscal tail-risk has been reduced. Whether payroll datamaintains a trend above 175,000, which seems likely for the rest of H2-2013, is also
key. Another parameter is whether the housing market has absorbed the steep rise in
mortgage rates since May. The average 30Y fixed mortgage rate rose 76bps in two
months to 4.42% on average in July. Although we foresee a dip in the housing data in
the coming months in reaction to this steep increase, we expect a rebound later in
the year as the economy gains traction, the labour market continues to improve, and
wage growth accelerates. We do not expect tapering to derail the continued housing
recovery. This will warrant a cut in MBS purchases from Q1-2014, in our view.
Figure 1: Standard Chartered US rates forecasts
Q3-2013 Q4-2013 Q4-2014 Q4-2015 Q4-2016
Fed funds target rate, % 0.0-0.25 0.0-0.25 0.0-0.25 0.75 1.75
5Y US Treasury yield, % 1.55 1.70 2.50 3.10 3.70
10Y US Treasury yield, % 2.75 2.90 3.75 4.00 4.25
Source: Standard Chartered Research
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On the Ground
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The Fed is changing its mix of tools, not the level of accommodation
A key uncertainty surrounding our call for September tapering is how the Fed will
reconcile a reduction in bond-buying with a likely downgrade of its 2013 growth
forecast. Even if Q2 growth is revised higher, the current Fed forecast of 2.3-2.6% y/yfor Q4-2013 growth (mid-point: 2.45%) implies growth north of 3.0% in H2, which
looks too optimistic. But we think the Fed can still argue that a sharp acceleration is
likely in 2014, with growth heading towards 3%. The new forecasts for 2016 are likely
to be upbeat as well. In other words, the outlook looks promising. Furthermore, the
inflation forecasts both for 2013 and 2014 are likely to stay broadly unchanged,
allowing tapering to proceed as the doves concerns about disinflation are addressed.
The second factor behind our tapering call is the Feds rhetoric. Since this spring it
has become clear that the Fed, including Chairman Bernanke, has become more
worried about the costs and risks of QE versus its benefits. Bernanke has signalled a
preference for conditional forward guidance, linked to a 6.5% unemployment rate,and separate from QE. The Fed will still provide the same level of accommodation,
but using a different mix of tools, as Bernanke emphasised at Julys congressional
testimony. Putting forward guidance in the drivers seat is also a way to keep market
expectations in check when tapering starts. Bernanke has reiterated the message
tapering is not tightening, which the market has gradually understood. Some doves
may argue that starting tapering now will prove that the exit of unconventional
policies is possible, and it can be smooth. QE remains relevant as a policy tool.
Bernanke, who has a theoretical bias towards the stock rather than flow approach to
policy accommodation, is expected to highlight the FOMCs decision taken in June to
keep the MBS portfolio to maturity as another way to provide accommodation.Bernanke is also likely to hint that the 6.5% unemployment rate threshold can be
lowered, as he said during Junes press conference.
Lowering the unemployment threshold would be a further way to send a dovish
signal, although we believe that in practice, the Fed is unlikely to change this
threshold in the short term. We see three main reasons: (1) This may create
confusion and affect the Feds credibility, as the current 6.5% target is quite recent;
(2) the FOMC will be reshuffled in 2014, and the Fed may want to avoid putting too
many ex-ante constraints on future members, and (3) lowering the threshold to 6%,
for instance, could mislead markets about the steepness of the rate-hiking path after
the first hike occurs. A 6% rate is close maybe too close to the full-employmentrate, which the Fed sees between 5.2% and 6.0%, a level which would in theory
warrant a neutral policy rate of around 4%.
The annual Jackson Hole meeting, on 22-24 August this year, usually provides the
Fed a platform for additional insight into its rhetoric, but this year the meeting may not
be as important as in the past. Bernanke does not plan to attend, while Vice
Chairman Yellen will only moderate a panel discussion, so there is no keynote
speech setting the tone for policy change.
A third factor for our tapering call is the level of asset prices, which plays an
important role via confidence and the wealth effect. One of QEs goals was areflation of assets following the global financial crisis, especially housing, specifically
through agency debt and MBS purchases. Our own index of the wealth effect shows
that in nominal terms, the level of wealth is back to pre-crisis levels, although house
September taper ing wi l l coincide
with a likely downgrade of the Feds
2013 growth forecast
The Feds rhetoric has evolved: QE
is losing i ts sh ine within the FOMC;
forward gu idance is preferred
Chairman Bernanke wi l l l ikely re-
emphasise tapering is not
tightening
Jackson Hole wi l l be no Delphi this
year
The weal th effect has worked, a
fur ther reason to expect QE
taper ing soon
We bel ieve the Fed is un l ikely to
change the 6.5% unemploym ent
threshold soo n
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prices are still lower. The Fed can now argue that there has been much progress in
this area, another reason to slow the QE programme.
Our prism for analysing QE taperingWe expect the first reduction in QE to happen in September (although this is still a
close call). We lay out below the three parameters that we believe will dictate the
timing and subsequent pace of QE reduction:
1. The data is key
The Fed has highlighted that it will take a holistic view of the data before tapering,
and the FOMC is at loggerheads about what constitutes enough improvement in the
economy. Still, we believe data on the labour and housing markets is particularly
important for the tapering outlook. We think there will be a steady acceleration in
growth, which supports a steady tapering path until Q2-2014, when QE is likely to
terminate.
In recent months, the Fed has emphasised its concern about the continued
undershooting of its employment mandate, which probably explains why it has tied its
policies more explicitly to the unemployment rate. Now, both the QE programme and
the forward guidance on rates have explicit unemployment
