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27 May 2013
Economist Insights Numbers speak louder than words
Markets got excited last week by talk that the Federal Reserve might be tapering quantitative easing this year. This was reading too much into the Fed basically saying what it had said before, that tapering of QE will depend on the state of the economy. The market should focus much more on examining future data releases than on what is said today. The Fed considering its exit strategy is simply ordinary risk management. Even if the Fed does start tapering QE this summer, it would not mark the start of a tightening cycle. The stock of QE would still be increasing each month, it is just that the rate of increase would be slower – not as exciting as the market made it out to be. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management firstname.lastname@example.org
Gianluca Moretti Fixed Income Economist UBS Global Asset Management email@example.com
The last few years have been pretty boring for traders in short-maturity US Treasuries. Shorter-maturity bond yields depend most closely on market expectations for the path of the Federal Reserve’s target rate. When the economy was in recession, it was clear that the Fed was going to keep rates low, and then after the weak recovery began the Fed committed to keeping rates on hold for several years. This took the fun out of trading the short end of the Treasury curve. Now there is talk that the Fed might be tapering quantitative easing (QE) this year, bond traders are hoping that things might get interesting again. Inevitably, this excitement means that the market is reading far too much into every utterance from the Fed. Previously bored traders want something to speculate about, because speculation generates trade volumes. And it worked. Consider the market response last week to the minutes of the last Fed meeting and Congressional testimony from Chairman Bernanke: daily trading volume in 10-year Treasury futures reached the highest level in history. The 10-year bond yield jumped more than 15 basis points (see chart 1), the largest intraday move since September 2012. This was a pretty big move on the back of the Fed saying basically the same thing that it had been saying before: tapering of QE will depend on the state of the economy. It is fairly pointless to scrutinize every word from Fed speakers for clues as to when tapering will begin, since those speakers themselves have not yet decided. The most that any analysis can reveal is a suggestion of each Fed decision-maker’s
reaction curve: some are more likely to vote to begin tapering QE in response to a given economic outcome, while others are more dovish. But unless you have a view on what the economy will look like over the next few quarters you cannot say when tapering will begin.
Chart 1: Jumped up Intraday movement in 10-year yield on 22 May 2013, times shown are London times 2.10 2.05 2.00 1.95 1.90 1.85 1.80 1:00 AM 3:09 AM 5:14 AM 7:32 AM 9:50 AM 12:08 PM 2:26 PM 4:45 PM 7:03 PM 9:49 PM
Chairman Bernanke has made clear that a premature monetary tightening could threaten the recovery, and he reaffirmed this position last week. This makes it very clear that the market should focus much more on examining future data releases (and what the Fed says about those releases) than on what is said today.
Most of the wording that got market participants so excited is to do with discussions of exit strategy. But this is simply ordinary risk management on the part of the Fed. We no longer live in a simple world of a single interest rate variable: monetary policy is vastly more complex so the Fed needs to spend some time during meetings discussing the possibilities. Before, the exit strategy would be ending rate cuts and then beginning rate hikes. Now it could be interest rates, tapering or reversing QE, reverse ‘twist’, forward guidance, etc. As always when interpreting official statements, ask what the counterfactual would be. It would actually be very worrying if the Fed was not discussing exit strategy. Discretion in monetary policy always comes at the price of market volatility. By removing their discretion for a while and committing to keeping rates on hold, the Fed basically eliminated volatility at the front end of the curve. Curiously enough, open-ended QE worked the other way. Because the Fed had reintroduced discretion into its policy decision (when and by how much does QE taper or stop), it actually created more uncertainty. Taking stock Even if the more bullish expectations are right and the Fed starts tapering QE this summer, this does not mark the start of the tightening cycle. The clear position of the Fed is that it is the stock of QE that matters, rather than the flow. Purchases under QE must be made at a certain pace because of what the market would be able to absorb, not because the pace is the policy instrument. The stock argument has a lot of common sense behind it: if the Fed makes no purchases today, but announces that it will make purchases next month, will the market wait until next month to react? Similarly, if the Fed decided to bring next month’s purchases forward into this month, the total buying over the two months would be the same so would a market reaction be justified? In the Fed’s view, even after tapering begins, it would still be increasing monetary easing because the stock of QE would be rising. It is just that monetary easing would be increasing
more slowly after tapering. When QE has stopped, the Fed will see policy as moving sideways – i.e. remaining easy. So tapering QE is not the turning point in monetary policy, but rather the inflection point. It would mark the change in the rate of change of monetary policy, which hardly sounds as exciting as the market makes it out to be. The difference that comes from QE is not huge. If the Fed begins tapering in August 2013 as opposed to January 2014, that would only mean a difference of about 11% in the total amount of QE outstanding (chart 2). Compared to QE continuing at the current pace until the end of 2014, the amount of QE would be about 27% less, which is substantial but hardly a reversal of policy stance. Given these small amounts, markets should really be spending more time looking at the data. For the Fed, numbers speak louder than words.
Chart 2: Tapering off Total amount of purchases outstanding under the Fed’s quantitative easing programme, USD trillions 5 4 3 2 1 0 Jan-09 Jan-10 Current Pace
Jan-11 Jan-12 Tapering from August
Jan-13 Jan-14 Jan-15 Tapering from January
Source: Federal Reserve, UBS Global Asset Management
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