Divyang Shah, IFR Senior Strategist
(Updates with more thoughts)
The Fed’s failure to taper despite a market that was prepared and priced for a shift has created a squeeze in positions across almost all asset classes. But it also leaves a lot of uncertainty on the Fed’s reaction function and in particular taper timing (Oct vs Dec) as well as questions marks over its communications strategy.
The Fed talked the talk but did not walk the walk. Or was it simply a matter of the markets not listening hard enough?
Whatever way you want to slice it the fact is that financial markets received a big surprise as the Fed held off on tapering or even strengthening the forward guidance. This was despite the statement telling us that the data was largely as they expected it to be saying “the Committee sees the improvement in economic activity and labor market conditions since it began its asset purchase program a year ago as consistent with growing underlying strength in the broader economy”.
The explanation for not tapering was that the Committee decided to “await more evidence that progress will be sustained before adjusting the pace of its purchases”. Two factors that stand out as concerns for the Fed are higher mortgage rates as well as fiscal policy. While the former is easy to understand it’s not a new factor and the higher mortgage rates were a result of the Fed’s communication. The Fed could have spoken about both in the run-up to the meeting.
Will the 6-weeks between now and the October meeting be sufficient to provide the Fed with the more evidence they need or will they need to wait until December or even early next year? This is the uncertainty that financial markets will have to grapple with over the coming weeks beyond the no-tapering inspired risk rally. The markets will need a stronger and more specific signal from Fed speakers on the timing of tapering beyond the normal data and Fedspeak.
But there is a less positive takeaway form the Fed holding off on removing policy accommodation and this is that the FOMC expects messy budget battles in Washington. If concerns over these battles prove to be unfounded then what we could be looking at is a speedier tapering cycle. Either the prospect of a messy budget battle or speedier tapering are scenarios that will create volatility and weigh on risk markets beyond the current euphoria.
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Time to take the other side of curve flattening?
The Fed’s decision not to taper has seen risk markets rally across the board but more importantly for the BoE and ECB is the relief provided by flatter money market curves.
Both the BoE and ECB have found it difficult to keep market rate expectations in check despite adopting forward guidance which for both central banks was a big step.
But it took a dovish Fed unwilling to start the tapering process to provide a real kicker to money market flattening which has seen 12x24 EONIA forward down 7bps while 12x24 SONIA is down 13bps.
The Fed has delayed not abandoned its plans to taper QE and with the price action reflecting a squeeze we would take the opportunity to go the other way on both 12x24 EONIA and 12x24 SONIA by paying at 0.375% and 0.695% respectively.