Taper

Federal Reserve Initiates Token Taper. What Comes Next?

Yesterday, the Federal Reserve announced that it will soon begin reducing the pace of its monthly bond purchases later in November. Step 1 in pulling back on the easy monetary policy the Fed has laid down to help the markets and the economy during the pandemic. This is because the Fed said, “In light of the substantial further progress the economy has made toward the Committee’s goals since last December”. We are talking about inflation and employment. A bit on that in just a bit.

The tapering is as expected. Instead of $120 Billion per month on monthly bond purchases, the number will be reduced to $105 Billion, a reduction of $15 Billion. The numbers workout like this: $70 Billion in Treasurys (used to be $80 Billion) and $35 Billion in Mortgage-backed securities (used to be $40 Billion).

However:

“The Committee judges that similar reductions in the pace of net asset purchases will likely be appropriate each month, but it is prepared to adjust the pace of purchases if warranted by changes in the economic outlook,” the committee said.

Still a lot of uncertainty as inflation expectations were only slightly adjusted. The Fed admits inflation has been more rapid than forecasted, and expects inflation to continue through mid 2022.

“Inflation is elevated, largely reflecting factors that are expected to be transitory,” the statement said. “Supply and demand imbalances related to the pandemic and the reopening of the economy have contributed to sizable price increases in some sectors.”

Still using that word. Transitory. And it is all about supply chain issues, which the Fed believes will be resolved next year. As someone versed in Classical economics…I have a feeling inflation will continue not due to the supply chain issues, but because of the money supply situation. But this will be more apparent in the next few months.

With the taper, a lot of analysts are now talking about interest rate hikes. This is where you can say things got a bit dovish. There was no mention regarding rate hikes for next year.

“We don’t think it’s time yet to raise interest rates,” Powell said. “There is still ground to cover” before the Fed reaches its economic goals. He added he wants to see the labor market “heal further, and we have very good reasons to think that will happen as the delta variant declines, which it’s doing now.”

The Fed has said in the past that they don’t expect to hike until after the tapering. On current schedule, this would be in July 2022. Let’s see what the market is pricing in currently shall we?

Taking a look at Fed Futures, this is what I see for the probabilities for the first rate hike:

A 23.2% chance of a hike in May of 2022. March 2022 sees a rate hike probability too, but it stands at a 10% chance at time of writing. Going into June 2022 and beyond, probabilities increase dramatically.

A 45.3% probability of a rate hike in June 2022, and probabilities remain high after that. So right now, even though the Fed did not say anything regarding rate hike expectations, the market is expecting them in the second half of 2022. Even predicting more than 1 hike as the 50-75 and 75-100 target rate bars indicate. Those also increase as we go past June 2022.

When I say uncertainty, I really mean it. The big elephant in the room is inflation. If inflation picks up and continues higher throughout the next few months, the market may expect the Fed to hike interest rates to combat inflation. Another central bank has done this…and the markets began to fall but I will leave you in suspense until next week. That country’s central bank is raising rates because inflation is hitting 10 year highs and sees no ‘transitory’ inflation. In the US, we are seeing inflation hit 30 year highs, but the Fed says it is transitory. As you can see, different central banks are seeing different things.

Just today, one other Central Bank took a hit to its credibility. The market expected the Bank of England to raise rates by 15 basis points to combat rising inflation. They did not. Their bond buying program of $1.22 trillion (£895 billion) remains unchanged. But the Bank of England said rates will rise in the upcoming months to combat inflation. They have said it, and now they must do it. I mention this because credibility and confidence is huge. If rates do not rise, that confidence begins to fade. Makes things more interesting especially if rate hikes would bring down governments who have had to take on more debt during the pandemic. A rise of interest rates means governments will need to pay more on the interest.

This is why this entire tightening cycle we are going to go through is going to be interesting for a student of economics and economic history…and will be wild for traders and investors.

The stock markets reacted positively to the upcoming Fed taper. Either markets don’t care, or it sees this as a token taper. I mean $100 Billion plus worth of purchases is still on going to prop markets and the economy.

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New record highs on the S&P 500, the Dow Jones, the Nasdaq and even the Russell 2000.

How about Bonds and the US Dollar?

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The 10 year yield is declining currently. It just remained in a range after the Fed announcement.

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Meanwhile bonds sold off, as they should on that news. However, today we are now seeing a rise in bonds this morning. Is it because the market is not expecting more taper? Or is it because of risk? This is where things get tricky using bonds and the US Dollar.

TradingView Chart

The US Dollar dropped yesterday, but today it is ripping. This is what we should expect on a taper and a more hawkish Fed. One thing for you all to note: Gold and Silver and other commodities are rising even on a strong Dollar! Inflation trade or risk off?

To do so going forward, I would now keep my eyes on the Japanese Yen, the Swiss Franc and the VIX. If money is running into Bonds, the US Dollar, the Japanese Yen, the Swiss Franc and the VIX…then uh oh. Right now, it is just the VIX which is red today but it is holding a support zone.

 

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