Wall Street Moves Up Taper Timeline As Fed ‘Taken Literally’

The Fed pretty clearly believes the market is prepared to deal with a reduction in the pace of monthly asset purchases. Officials have said as much on innumerable occasions over the past several months.

This debate took on an extra sense of urgency following the July Fed minutes — or at least according to various attempts at explaining cross-asset behavior on Thursday. The manic behavior in US equities was at least partially down to the dynamics discussed in “We May Be ‘On The Verge’ Of A Cascade,” but the malaise in commodities and generalized sense of angst was blamed on the minutes’ explicit reference to tapering by the end of “this year.”

To be sure, most investors expected a taper unveil over the next four months, but expecting it and expecting the market to digest it with alacrity are two different things. I’m inclined to believe they’ll be some indigestion.

As I’ve emphasized repeatedly (and I say “I’ve” not to suggest my take is somehow unique, let alone definitive, but rather just to give myself an excuse to link to a previous article which new readers might find useful), the issue isn’t some mechanical relationship between monthly bond-buying and risk assets. Indeed, definitively establishing such a correlation is notoriously difficult to do. Every bank has tried it. The linked article below is, I think, informative in that regard.

Read more: Lyin’ Eyes And Taper Tremors

I won’t recapitulate at length, but in light of all the taper headlines, I’d be remiss not briefly recap. It’s far more useful to think about the relationship between QE and risk assets (e.g., equities) from a common sense perspective, and there are any number of ways to go about that.

Most obviously, ample liquidity is bullish — it just is. As Harley Bassman put it, referencing global QE, “$20 trillion of money must reside someplace, and with the magic of financial leverage it’s quite clear where.”

Beyond that, I’m a (big) believer in the notion that the “flow” of monthly asset purchases matters more than the so-called “stock effect.” The latter is multi-faceted, but part of the argument is that the artificial scarcity created by sequestering safe assets on central bank balance sheets preserves the hunt-for-yield environment. There’s quite a bit of truth to that, but common sense dictates that having a price-insensitive, marginal buyer in the market each and every month is a huge boon, and the bigger the “better.” So, as that “flow effect” (illustrated in the figure below) is scaled back (i.e., tapered), risk assets might suffer.

Finally, I’d note that if we learned anything at all from the Q4 2018 mini-bear market, it should be that merely talking too much about the Fed’s balance sheet can create a huge psychological overhang (there’s much more on that in the “Lyin’ Eyes” article linked above).

With all of that in mind, note that multiple banks changed (or “tweaked”) their taper timelines following the release of the July Fed minutes.

“Taken literally, the comment in the minutes that most participants ‘judged that it could be appropriate to start reducing the pace of asset purchases this year’ implies a formal announcement by November rather than December because reductions are not implemented until the month after announcement, though this might be too literal a reading,” Goldman wrote, on the way to raising their odds of a formal announcement in November to 45% (from 25%) and lowering December’s odds to 35% (from 55%).

“If the FOMC does intend to taper in November, we expect that it will want to include a formal warning in the September FOMC statement, and Chair Powell might also include a hint in his Jackson Hole speech,” the bank went on to say, adding that they “still see a meaningful chance that the formal announcement will come after November because of the considerable uncertainty about the impact of the Delta variant on the economy and the possibility that mediocre data could delay the FOMC’s advance warning past September.”

If the Fed tapers $15 billion per meeting following a November unveil, the final taper could come next September. Goldman’s base case on liftoff is still Q3 2023. (Recall that the minutes contained multiple references to de-linking liftoff timing from the taper schedule.)

Meanwhile, BofA pulled their base case on the start of the taper to November from January 2022. “November appears the most likely time to start taper due to the Fed calendar and operational considerations,” the bank said, noting that “September seems too early to start a taper” given the commitment to giving the market ample notice. BofA noted that December probably won’t work because the Fed would have to effectively pre-announce the taper in the monthly schedule of Treasury and MBS purchases on the 13th, before the December FOMC meeting.

Finally (and I don’t see much use in highlighting more than three separate takes on the minutes), TD’s Jim O’Sullivan said that in the bank’s view, “the minutes make a taper announcement as soon as the September meeting highly unlikely.” They’re sticking with their call for a formal taper announcement in December, although O’Sullivan conceded that “November remains possible if the next two employment reports are unexpectedly strong.”

I suppose all I’d add is that there’s a benefit to making major policy changes at meetings associated with new SEPs. The problem this time is that September is pretty clearly “too early” unless Jerome Powell plans to tip the announcement at Jackson Hole and assuming the labor market doesn’t completely run out of momentum, December may be too late, to the extent anyone at the Fed is actually worried about appearing reckless (admittedly a debatable proposition).

I’d reiterate that while it still seems unlikely that the Delta variant will derail the taper, lingering concerns about the virus may well mean that any attempt at normalization will prove feeble and possibly fleeting. As noted here on Thursday, there’s always an excuse to kick the can.