The US economy slowed in the months since the idea of QE3 tapering was first floated. In light of recent price developments, we examine the case: to taper or not to taper?
The Federal Reserve’s balance sheet has jumped by over $3 trillion since the global financial crisis erupted in 2008. QE1, the first large scale asset purchase (LSAP) program was bold: it mind as well as saved the entire global economy. Just how bold? Fed Chairman Ben Bernanke won TIME Magazine’s coveted “Person of the Year” anointment in 2009.
QE2 was similarly successful, but not met without its critiques. A $600 billion bond-buying program was nothing to shake a stick at; it propelled global equity markets higher from November 2010 through June 2011, before the Euro-Zone crisis decided to wake up and the U.S. lost its ‘AAA’ rating at Standard & Poor’s for continued political brinkmanship (which continues today).
QE3 has proven to be the least effective and most controversial easing plan to date, more so than the even bolder measures taken in Japan by the government and the Bank of Japan, collectively known as ‘Abenomics.’ When the Fed announced QE3 in September 2012, market pundits were convinced that U.S. yields would plummet and the U.S. Dollar would be thrashed – more of the same of QE1 and QE2. QE3 was dubbed “QE-infinity” given its open-ended nature. But instead, with the U.S. economy improving, and yields shooting up in favor of a stronger U.S. Dollar, there’s growing support inside and outside of the Fed for a reduction in QE3.
There are several reasons to taper and not to taper, and they will be weighed by the Fed at its future meetings as the central bank eventually winds down its purchases. On the positive side, the fiscal drag thanks to the budget sequestration has proven much less daunting than previously forecasted, and the U.S. fiscal deficit is falling at its fastest rate in over 50 years. The U.S. unemployment rate is now at 7.0%, as low as it’s been since 2008.
The negatives are evident as well. Labor market growth has slowed in recent months, and Nonfarm Payrolls figures have eroded through midyear. Consumption has started to fall, and that may be a symptom of recently higher interest rates; higher borrowing costs reduce disposable income, and with wage growth dead, it is likely that higher rates remain a negative influence on the U.S. economy. These consumption fears have manifested in soft inflation figures throughout 2013.
Whether or not the Fed tapers QE3 will be determined shortly, but given the meteoric rise in U.S. yields the past several months, any outcome – even a $15B taper – could provoke a pullback. Consider that within the past six months, the U.S. Treasury 10-year note yield was as low as 1.631% on May 2, and had risen to as high as 2.979% on September 5 – over a 40% increase.
We thus suggest: if the Fed decides only on a modest taper $0B-10B/month, there is a significant scope for U.S. yields to pullback. Between $10B-20B/month, recent downside pressures in emerging markets and upside pressures in U.S. yields will remain; these will continue to manifest into further emerging market FX and high yielding FX weakness.