The absence of a nod to the effects of the recent government shutdown — and the ongoing fiscal crisis in Washington, D.C. — in yesterday’s October FOMC statement is causing a wholesale re-think across Wall Street about when the Federal Reserve is most likely to begin tapering down its quantitative easing program.
The big question left unanswered by this omission from the statement is this: how does the fiscal crisis factor into the FOMC’s assessment of the economic outlook?
Before yesterday, economists and strategists believed the most likely timing for a tapering announcement was the FOMC’s March meeting.
The rationale was that the Fed had cited both inadequate improvement in the economic data and the upcoming fiscal storm in D.C. as reasons for refraining from tapering in September. On the first point, no one really expected there to be enough incremental data in the next few months to suggest an inflection point economic growth.
Meanwhile, D.C. agreed to simply postpone the budget and debt ceiling fights to January and February, respectively, meaning we could get a repeat of the October episode fairly soon, with more downside risks to the economy.
So, not only did most expect tapering to be off the table until March, but some were worried that it could be even further off than that.
“There is a danger that the Fed has missed its window of opportunity,” said Paul Ashworth, chief U.S. economist at Capital Economics, in a note to clients last week. “If it’s waiting for some degree of fiscal certainty, this really could turn into QEternity.”
Likewise, George Goncalves, managing director and head of rates research at Nomura, asserted prior to yesterday’s meeting that a fiscal “Grand Bargain” was “the only way to eventually fully get off the Fed QE crutch.”
In fact, the general consensus on the Street prior to the release of yesterday’s statement was that the FOMC would confirm the views of market participants that tapering was off the table for a few months by tweaking the language of the statement to acknowledge the fiscal crisis — but that didn’t happen, and now, market expectations for the beginning of the end of QE are being pulled forward.
“In terms of the actual tapering path that the market believes, we are far from the early September path,” says Steven Englander, global head of G-10 FX strategy at Citi. “The biggest concentration of probability now is that tapering begins in the January-March period versus March and beyond two days ago.”
For his part, Capital Economics’ Ashworth believes “sometime early next year is the most likely outcome, but the balance of risks just shifted a little.”
“If officials are trying to downplay the impact of the shutdown and are happier with the level of long-term interest rates, then perhaps a December taper isn’t quite as out of the question as we had previously thought,” he writes in reaction to the October FOMC statement.
But is that really what the Fed was doing?
Nomura’s Goncalves is not convinced.
“We are perplexed why traders and the media are focusing on the first sentence in the third paragraph [of the October FOMC statement] that addresses their views on the fiscal impact, which was basically a repeat,” he writes in a note. “They continue to state that given ‘the extent of federal fiscal retrenchment over the past year’ they are still viewing QE as a success and that due to their asset purchases it has resulted in improving economic activity and labour market conditions, which are consistent with a growing economy. Granted, by leaving this point basically intact, the market believes they are trying to put a positive spin to their messaging, but can it last?”
Goncalves still thinks the answer is no.
“They need to continue to sound optimistic — got it — but to taper they will still need the data to improve and the D.C. fiscal fights to go away, which doesn’t seem likely in our view,” he says.
We may get some more clarity on how the FOMC views the effects of the shutdown starting Friday, with speeches by St. Louis Fed President James Bullard, Minneapolis Fed president Narayana Kocherlakota, and Richmond Fed president Jeffrey Lacker on the calendar.
“What will matter in coming days is how upcoming Fed speakers spin their decision,” says Citi’s Englander. “Asset markets will come under pressure if they keep repeating that tapering isn’t tightening because they have a powerful forward guidance weapon at their disposal. Investors do not believe it. If they stress that the weak data will not make them comfortable with tapering for a good while, risk gets bought again.”
The release of the statement sent 10-year Treasury yields up as investors sold the bonds in anticipation of a taper sooner rather than later, and today, an unexpected surge in the ISM’s monthly Chicago Purchasing Managers Index is sending them higher still — not least because ISM said in the report that businesses were “seemingly unaffected by the [government] shutdown.”
Today, the 10-year yield trades at 2.56%.
“Markets are skittish any time the Fed doesn’t validate that the ‘carry trade’ is a-ok, and that means pushing bond markets — [10-year Treasury yields], for example — [down] through 2.5% will require weak data & round 3 of fiscal fight,” says Goncalves. “Unfortunately, we think it’s coming.”