Divyang Shah, Senior IFR Strategist
1) the Fed has mapped out a strategy for winding down QE
2) it might not be the “clear and steady path” markets expect, and
3) the timing of when to start is still “being debated”. What is important for markets is that “clear signals” could emerge this week when we have a lot of regional presidents (especially Thursday) as well as Chairman Bernanke (Saturday, May 18) all making speeches.
When the Fed delivered its statement on May 1, the addition of the phrase “increase or reduce” QE was intended to provide the Fed with maximum flexibility as it eventually moves toward exiting QE.
What we learn from Hilsenrath’s latest article is that the road map has been prepared. While the timing is uncertain, it seems that this will depend upon making sure that market expectations have been adjusted to the game plan. The Fed has time on its hands as it looks to see whether the economy will disappoint, as it has done “for several years during the spring and summer months”.
The market expectations adjustment aspect is important, and the Fed seems intent on not repeating the mistake of the last easing cycle when it is generally regarded that low interest rates overstayed their welcome. While the Fed is cognisant that an abrupt or surprising end to QE could send stocks and bonds lower, a delay would allow markets to “overheat”. The latter is important in the context of a resurfacing of the phrase ‘dash for trash’ in some commentaries in the latest run-up on risk assets.
It will be interesting to see whether the exit from QE will be similar to the exit from low rates during the 2003 to 2006 period when predictability of policy did little to calm excessive risk taking.
The impact of an eventual end to QE is likely to be twofold:
1) as the liquidity tide moves out we might find that it was this that helped peripherals more than the “whatever it takes” comments from Draghi, and
2) the USD is likely to strengthen significantly further, especially against the JPY, which will lead to trade tensions and a further rise in currency war tensions.
This week’s Fedspeak is going to be very important for risk assets, and given the likelihood of further USD strength over the coming months we would look to buy USD calls vs the EUR and JPY. A 3-month 1.25 EUR put/USD call with knock-out at 1.33 costs 56bp (0.43%), while a 3-month 108 USD call/JPY put with knock-out at 99 costs 50.5bp (0.495%) – all prices using FENICS.
