Divyang Shah, Senior IFR Strategist
The process of adjusting market expectations started with the release of the December FOMC minutes early this year when the Fed highlighted the costs could start to outweigh the benefits of QE. In those minutes the key concern of those that had favoured purchases to “slow or to stop” were the costs related to “financial stability or the size of the balance sheet”. Subsequent minutes of the January FOMC meeting showed that “several participants” were in favour of varying the pace of asset purchases.
However, several others wanted to keep asset purchases until a substantial improvement in the labour market had occurred. SF Fed’s Williams was in this other camp wanting to see the labour market improve but in his recent speeches he has shifted toward potentially tapering QE “as early as this summer”.
The fact that Williams is no longer looking for the labour market to improve highlights how even the doves are started to be worried about the impact that QE is having on financial stability.
Chairman Bernanke will likely communicate the shift in sentiment toward QE when he testifies at the JEC this Wednesday. But a key part of the message is likely to be the uncertainty faced by the Fed who in reacting to financial stability concerns could find itself being forced to focus more on labour market, economic weakness or low inflation further down the road. Which is why the Fed talks in terms of “dialling back” QE as this conveys flexibility in being “prepared to increase or reduce the pace of its purchases”.
Given that the Fed is focused more on financial stability concerns it will look to contain fallout on asset markets by highlighting that:
1) tapering QE means less accommodation and not tightening of policy, and
2) even if QE ends, the bar for higher interest rates remains high.
The nuances are likely to be expanded upon by the Fed and should help to prevent a sharp selloff on risk/equities as well as preventing bond yields from rising sharply.
Given that the Fed will attempt to divorce expectations of tapering/end to QE from expectations of the first rate hike the Treasury curve should steepen. The 2s/10s Treasury curve could steepen all the way back to 280bp from its current level just under 170bp.
