Tapering Untangled 15-08-13

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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

    [email protected]

    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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    On the Ground

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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