The Fed's Dilemma and the Week Ahead

US foreign and domestic policies face cruel dilemmas. If the ban on chemical weapons is not enforced, the threshold will be more difficult to defend in the future. It risks undermining the credibility of the US, especially after a specific warning was issued. On the other hand, to strike without public support and a clear objective outside of punishment, a military strike also risks US credibility.

Monetary policy is far removed from the military issues, but has its own battle and credibility is arguably as important. In the spring, Fed officials indicated that with the economic recovery gaining traction, it would dial down the amount assets being purchased under the open-ended QE. Taking their clues from the Fed’s guidance, a full two-thirds expect the central bank to announce the tapering this week.

If the Fed fails to deliver, it will reinforce the criticism about the Fed’s communication effectiveness. Yet if the Fed tapers and demonstrates that its communication has indeed been effective as the majority of market participants correctly anticipated the tapering, it risks repeating its previous mistakes when it ended previous QE operations prematurely. Financial and economic conditions deteriorated and officials were forced to resume their asset purchases.

The Fed had traditionally eschewed a formal inflation target. The Bernanke Fed broke with tradition and adopted one. Yet, it appears poised to taper despite inflation being well below its target. In fact, as we have noted previously, the core PCE deflator is lower now than when the then-Fed governor Bernanke went to great lengths to explain the deflationary threat.

Headline inflation regresses to core inflation and core inflation tends to regress to labor costs. Labor costs in the US remain low and with the slack in the labor market, they are unlikely to pick up substantially any time soon.

At the same time, the Federal Reserve has habitually exaggerated the growth prospects of the US economy and has had to repeatedly reduce its forecasts for GDP. Its forecasts for this year’s GDP remain too high. They need to be cut in order to restore their credibility. 

Can the Fed taper to retain its communication credibility and at the same time cut is GDP forecasts to retain economic credibility without undermining its overall credibility?

Moreover, it is not just monetary policy that will become less accommodative as the process of normalization begins, but fiscal policy is also tightening. The Federal deficit is falling faster than nearly any one anticipated and there is additional sequestration baked into FY14.  In addition, the risk is that additional spending cuts maybe agreed as part of a compromise to lift the debt ceiling.

The question is often asked, who will by US Treasuries as the Fed purchasing is first tapered and then ceases.  Yet, Fed purchases themselves likely deterred some investors and they can be expected to return.  Also, many emerging markets have drawn down reserves to smooth the exit of short-term capital and they can be expected to buy Treasuries to replenish reserves.  

The June Treasury International Capital report (TIC) showed that the two largest foreign holders of US Treasuries, namely Japan and China were heavy sellers.  However, this week's TIC report for July is likely to show a different story.  

Data from the Ministry of Finance shows Japanese investors bought US Treasuring in July for the first time this year and that the roughly $27 bln purchased is the most since March 2011.  Due to methodological differences this may not be fully reflected in the TIC data (e.g. if the Treasuries were purchased from non-US banks), but it nevertheless reflects demand for US Treasuries.  

There are mathematically only three possibilities: the Fed does what the market expects; it does less, or it does more.  Only under the last scenario would we expected US Treasuries to sell-off and for the dollar to rally and we would ascribe to it the lowest of odds.  We suspect the Fed is likely to do less either in terms of the size of the tapering and/or in the other guidance it provides that would aim at mitigating the impact.  In addition, while tapering may deter a hawkish dissent, given the low inflation, it is possible to elicit a dovish dissent.  

Although the FOMC is clearly the center of attention, it is not the only central bank is of interest in the days ahead.  The Swiss National Bank and Norway's Norges Bank meet that day after the FOMC meeting concludes.  Neither is expected to alter its policy stance.  Deflationary pressures are subsiding in Switzerland and the economy appears to be gaining traction.  However, officials have not signaled in any way that they are getting closer to an exit of their own.  That is likely to be more of a H2 2014 story.  The risk from the Norges Bank, on the other hand, is a bit more hawkish leaning after the surprise uptick in price pressures.  

Minutes from the Sweden's Riksbank and the BOE will be released the day before (on Sept 18). The likely takeaway from the former is that the is still a vocal minority favoring easing policy in the wake of the softening of the economy in the context of zero price prices.  The majority seems more concerned that lower interest rates will fuel additional household debt accumulation.  

The minutes from the BOE's meeting may be more interesting.  The UK economy appears to be building momentum, while inflation (latest figures to be released on Tuesday (Sept 17) remains at elevated levels.  At the July meeting (Carney's first) there was already one dissent (Weale) and it is possible that another member joined the dissent at the August meeting.   

Carney's forward guidance instead of new gilt purchases may be failing to forge a consensus at the MPC, in which former Governor King was repeatedly out-voted.   Nor has the forward guidance sway investors.  The market is pricing in a BOE rate hike a year or more sooner than Carney's forward guidance would have it.   

A new problem for the BOE is emerging and its Financial Policy Committee will hold a meeting on Wednesday, the same day the minutes will be released.  The FPC will discuss whether the housing market bubble is emerging, and if so, how it can be best addressed.  

Business Secretary Cable (Lib-Dem) expressed such concerns publicly last week and went so far as questioning the Help to Buy scheme (of government guarantees for mortgages offered to home buyers without large down payments).   Chancellor of the Exchequer Osborne (Tory) argued against claims of a national housing bubble, and BOE's Carney seems to agree.  In chess when one is in doubt, it is advised to push a pawn.  The equivalent in politics seems to be further study, which is the likely outcome of the FPC meeting.  

The summer is over and European politics heats up too.  Of course, the German election on September 22 is eagerly awaited.  Few doubt that Chancellor Merkel will be elected to a third term. The issue is whether she can achieve this with her center-right coalition, or will some broader, perhaps grand coalition, be necessary.  

We do not expect a fundamental shift in German politics. Merkel has maneuvered to take some of her oppositions thunder in terms of domestic policy initiatives.  Her European policy has long relied on support from the Social Democrats and Greens.  

Italian political pressure is intensifying and this is reflected in the debt markets as its 10-year yield has risen above Spain's for the first time in 18 months.   The Senate panel is scheduled to vote on enforcing the Berlusconi's ban from politics as a consequence of being found guilty of tax evasion, but this could be delayed. 

As Berlusconi is appealing the ex post facto conviction before the European Court of Justice, delays in the Senate process may seem to work in his interest.  A delay may work in Prime Minister Letta interest as well as it would allow to it continue to pursue its mild reform agenda. 

It would also work in the center-left's strategic interest.  Time is on its side as the conviction for paying a minor for sex and abusing his office makes it way through the appeal process.  Much of Berlusconi's defenses  and the sympathy in some quarters for former PM on the tax evasion charges go by the wayside with this conviction.  

Meanwhile the Troika is set to start its next review of Portugal's progress.  Ten-year bond yields in Portugal have risen through the 7% threshold again.  Our long held view that Portugal is going to need some more help is gaining credence, even though the Troika is still quite some distance for formally recognizing this.  

Any discussion of a private sector initiative (debt restructuring) will most likely continue to be denied, though the risks of such would seem to be increasing.   The price of insurance (5-year credit default swap) has risen from about 425 bp in early August to over 550 bp now and is within spitting distance of the year's high.  The 10-year yield has surged from about 5.3% in mid-May to 7.4%.   Moreover, the pace of the move has accelerated of late.   

The Troika will is sending a new review mission to Greece to start next week as well.  There is widespread acknowledgement that a funding gap has opened in Greece.  The issue is how will it be closed.   Look for more progress on the issue by the middle of next month.   

The Fed's exit (from QE) is the most important macro development this week, overshadowing high frequency economic data reports and events.  While the ECB seems far from exiting its highly accommodative policy (including full allotment of repos) and has discussed (and may deliver) another long-term repo, the EC must be contemplating the management of the exit of aid programs for Spanish banks, Ireland and Portugal.  An exit may not be possible in the time frame that is currently perceived for Portugal and it is possible that Ireland needs help, perhaps a precautionary line of credit,  to help facilitate a smooth and stable transition.