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What market surprises could Wednesday's Fed meeting bring?
09/17/2013 8:30 am EST
Something that seemed settled is wide open again. And the effects on the financial markets are certain to be far-reaching.
Can I envision anything nearly as surprising for Wednesday’s decision at the Federal Reserve’s Open Market Committee on beginning/not beginning to slow the pace at which the Fed is buying Treasuries and mortgage-backed securities? After all the markets have had months to masticate any tapering in Fed purchases. You’d think the decision would be priced into financial assets by now.
I don’t see much chance of a direct surprise. I think the big, liquid global markets—like those for Treasuries and currencies such as the dollar, yen, and euro—have discounted a modest Fed taper sometime before the end of 2013. In a recent Bloomberg poll 57% of investors say they don’t expect a sudden change in the markets if the Fed does decide to start a taper on Wednesday. Their reason? They say they already anticipate a Fed taper. I doubt that a Fed decision to taper on Wednesday or to wait until October is going to produce more than a blip in the markets that I’ve noted above—or in the big liquid developed economy stock markets.
But that doesn't mean I’m ruling out all chances of surprise. I think we could get a surprise in less liquid markets, which is where worry is most intense right now. That wouldn’t require a change in the markets just a continuation of recent direction.
And that reaction could circle back to the globe’s biggest asset markets. I doubt that’s likely or that any move in developed markets would be big or long lasting. But that’s definitely where I’d be looking in the last half of this week for any surprise.
Let me take you on a brief tour of potential surprises.
The Fed is currently buying $85 billion in Treasuries and mortgage-backed assets a month in order to lower medium-term interest rates. (The Fed controls short-term interest rates directly and has said that it will keep short-term interest rates at their current “extraordinarily” low level or 0% to 0.25% until 2015. The Fed has been trying to lower medium term rates in the vicinity of seven-year maturities.)
The consensus is that the Fed, whenever it begins to taper, will do so very modestly, cutting back purchases from $85 billion a month to $75 billion or so. The first surprise then would be if the size of the Fed taper exceeded $10 billion by a significant amount. A drop to, say, $70 billion, would be aggressive, but probably not enough to rattle the consensus. A drop to a level lower than that would indeed to a surprise and would undoubtedly lead to a sell off in both the bond and stock markets. I think the likelihood of a drop on that action is abundantly clear to the Federal Reserve.
And that’s why this surprise is so unlikely. The U.S. central bank wants markets to get used to the idea of a gradual withdrawal of stimulus. That’s what’s been happening for the last three or four months as bond prices have fallen and yields have climbed. On Friday, the yield on the 10-year Treasury closed at 2.88%. That’s up from 1.87% a year ago. In that period, though, U.S. stocks have continued to climb. The Fed wouldn’t mind an increase in 10-year yields to slightly over 3% or a mild correction in U.S. stocks on the order of the 4% to 5% pullback in August. But the Fed doesn’t want to whack the markets hard and risk endangering the U.S. economic recovery. The Fed will begin a taper in 2013 because it has signaled markets to expect that move and anything else would damage the bank’s credibility. But the bank doesn’t want to move so fast and hard that it risks the modest economic recovery that it has helped engineer.
Much more likely, but still not extremely likely, is a surprise in the mix of what the Fed buys. The current program buys $45 billion a month in Treasuries and $40 billion a month in mortgage-backed assets. To the degree that there is a consensus on how the Fed might balance a taper, it points to leaving purchases of mortgage-backed assets alone and reducing purchases of Treasuries. That consensus rests 1) on an belief that the Fed sees the housing sector as a key to keeping the economy in recovery mode so that the central bank won’t cut back its purchases of mortgage-backed securities because it doesn't want to see mortgage rates rise, and 2) on a belief that the Fed is feeling uncomfortable with its current holdings of Treasuries since Ben Bernanke and Co. have virtually become the Treasury market for these medium term maturities and would want to increase the market supply of these maturities.
This consensus will probably turn out to be correct but greater than expected reductions in the Fed’s purchases of mortgage-backed securities—whatever “greater than expected” might turn out to be—could temporarily spook mortgage REITs and housing stocks. I doubt that the Fed will increase any reductions in purchases of mortgage-backed securities in future tapering so I’d see any panic on a possible Wednesday surprise in this sector as an opportunity for a short-term trade.
Emerging markets seem most likely to turn a Fed taper on Wednesday into a surprisingly big deal. That’s because emerging markets are already worried about cash outflows and weakening currencies versus the U.S. dollar. And because any suggestion that the Fed might be beginning on the road to an eventual end to its bond purchases will set some investors and traders in these markets wondering when the Federal Reserve might begin to raise short-term interest rates.
I know. I know. The Fed has said it will keep short-term rates at current low levels until 2015. And Summers’ withdrawal from the race to follow Bernanke has removed the candidate most likely to have moved faster toward tightening than outgoing Fed chairman Bernanke.
But still emerging markets are worried and it would not take much to push them into contemplating—and worrying—about the unthinkable, an earlier than expected end to the 0% to 0.25% short-rates at the Fed.
In recent days we’ve seen the beginnings of what looks like a division of emerging markets into two groups:
First, those with more than adequate reserves and decent prospects for steady or even modestly increasing growth. The financial markets in these economies—China and Brazil, for example—have actually rallied recently. As of the close on September 13, Hong Kong’s Hang Seng Index was up 16% from its June 24 low and the Shanghai Composite was up 14%.
Second, those with big current account deficits, reserves that are relatively modest relative to those deficits, and economies that look like they’re headed for more slowing with a growth recovery uncertain. Here the biggest worry is India but Indonesia also belongs in this camp. India’s BSE Sensex is down 12% this year in dollar terms on a drop in the Indian rupee to a record low of 68.45 to the dollar on August 28.
If the Fed does indeed begin a taper of its asset purchases on Wednesday, that could be enough to set off another round of selling in the weakest emerging markets. These markets seem extraordinarily sensitive to sentiment on a taper—Indian stocks traded in Singapore—which open for trading before stocks in Mumbai—were up 1.6% in early morning trading on September 16 on the news that Summers had withdrawn his name from consideration for the Fed job.
That’s a big move in Indian stocks on speculation about who will become the next Fed chairman in January.
Contagion from weakness in India and/or Indonesia might work this way—by spreading to other emerging market areas of concern such as Turkey and then by focusing attention on the problems in Brazil and China that financial markets have decided to overlook in the last couple of weeks. For example, China’s economy shows signs of overheating that are remarkably like those that led the government to tighten credit—and thus to send Chinese stocks into retreat. Real estate prices in Beijing and Shanghai rose 14% in July from July 2012. New extensions of credit almost doubled in August from the previous month. Aggregate financing was 1.57 trillion yuan ($257 billion), well above the 950 billion yuan expected by analysts surveyed by Bloomberg.
To me that sounds like China’s growth problem isn’t fixed and that bank lending and asset prices may soon be out of control again—at least to a degree that would require tightening by the People’s Bank.
Right now investors and traders seem inclined to overlook that possibility. It wouldn’t take all that much of a negative showing in Indian, Indonesian, and Turkish markets to refocus their attention. And if China’s markets started to wobble again, I’d expect Australia and other export economies to show nerves to. Enough of that the Japan, the EuroZone, and the United States would notice.
How likely is this last surprise? As you can see from the length of the chain of causation that I’ve had to specify, it’s not highly likely. The Fed would have to spook India which would have to spook China which would have to spook U.S. markets.
But as I noted at the top of this post, the withdrawal of Larry Summers from the running for Fed chair should remind us that surprises do happen.
I suspect that Wednesday’s Fed news won’t cause a huge ripple in the financial markets. But I am keeping my eye on the “surprise horizons” that I’ve outlined here.
And don’t worry: If the Fed doesn’t produce any market rattling responses on Wednesday, we’ve still got the battles over the U.S. budget and the debt ceiling to look forward to.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any stock mentioned in this post as of the end of June. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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