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Monday, 23 October 2017

The Fed and Capital Markets

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Divyang Shah on why forward guidance is more important than tapering next week

Divyang Shah, Columnist

Divyang Shah, IFR Senior Strategist

A straight-talking Bernanke back in June revealed the script that the Fed will start tapering this year and look to end QE sometime in mid-2014.

Even if we are unsure of the exact path, that journey is expected to start next week with the QE total likely being shaved by US$10bn. Much more important, though, is whether the Fed uses the opportunity to tinker with its forward guidance, which is elevated in its importance once tapering begins.

While the Fed has succeeded in shifting market expectations toward tapering, it has been less successful in trying to divorce what it does on unconventional policy from the outlook for conventional policy.

The start of tapering means markets are a step closer to an eventual turn in the rate cycle, so it is only natural for forward-looking markets to focus on higher interest rates, especially given the low bar on the unemployment rate of 6.5% set by the forward guidance.

There are two avenues through which the Fed can look to adjust market expectations:

1) by providing a lower bound for inflation at 1.5% as well as an upper bound, and

2) by reducing the unemployment threshold to 6% from 6.5%.

This time is different

We have been down this road before on both, back in July, but it seems more likely now that these changes to forward guidance may be enacted. Such an announcement next week would do a lot to take the sting out of the start of tapering and create a friendlier environment for risk markets.

We have already seen a shift in emphasis, with influential FOMC member Evans (of the Evans rule that eventually gave us numerical thresholds) saying last week that he could “easily envision certain circumstances in which the unemployment rate could go below 6% before we moved the funds rate”.

We expect the post-FOMC statement, and more importantly the Economic Projections and the press conference from the Chairman, to be geared towards providing relief to markets on the rate outlook, which in turn should aid the ECB and BoE, who have both had to adopt forward guidance of their own to try to insulate their money markets from the steepening seen on the US money market curve.

We would look for money market curve flattening trades in to and out of the FOMC meeting.

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