We must give Jay Powell a clap – unlike the two predecessors he has managed to avoid a market tantrum with ambiguous language and communication discipline. These actions, in our view, have given us a clear playbook as to how the Fed will act over the next 12 months.
We should point out that any further out than this starts to become clouded by COVID, lift-off (rate rises), and data which in the current environment is near impossible to forecast.
So, let’s look at the playbook the Fed has given us around the balance sheet and its quantitative easing program.
The Fed’s playbook
The Fed has all but confirmed that at the November meeting will begin to taper its asset purchase program which stands at US$120 billion a month. It has also been confirmed that it will have completed its tapering program by mid-2022.
We believe that Powell’s use of ‘all but there’ indicates that the Fed has met the ‘substantial further progress’ test. He highlighted that the September payrolls report needn’t be particularly strong in other words the tapering decision is locked in come what may.
What does the tapering program look like and how will it proceed? The consensus is that the Fed will slow purchases at US$15 billion a month (the split is likely to be US$10 billion Treasuries US$5billion Mortgage Backed-Securities) starting each mid-month. Working that through from the start point of US$120 billion, a month suggests FOMC trajectory wrap up the asset purchase program is mid-June 2022.
There is a caveat – Powell maintained “optionality” around the taper seen in this line we can certainly speed up or slow down the taper if it becomes appropriate.
The main conclusion for the playbook is there is a clear separation between the balance sheet and lift-off. Powell highlighted that the path for rate hikes was different from that for tapering. In fact, he stated very clearly, that lift-off has a clear higher hurdle, the consensus on Powell’s position here is that he sees lift-off in 2023. That is despite the fact the dot plots now show 9 of the 18 members seeing rate rises in 2022.
That ‘high hurdle’ is clearly caveated economic developments which, as stated is clouded over the coming 12 months or so. Concentrate on upcoming payroll reports, and the possible offsetting of labour supply to expiring benefits, school reopening (Powell highlighted this point in the Q&A), and Delta effects. All are needed to get closer to the needed maximum employment.
How to play this
The consensus expectation is that we should start seeing higher US real yields which in turn should boost the USD. The pairs most likely to move from this scenario is USD/JPY and EUR/USD.
The JPY has historically declined 1.1% per month when US real yields ride. So, with the Fed giving us a bullish US real yields view a long USD/JPY targeting ¥112.50 is what most are suggesting.
Looking at EUR/USD looks to the EU-US real yield differential. European yields are expected to fall as the ECB stated it is considering a re-calibration of its asset purchases, but that it is not tapered.
This policy should weigh on EUR, so look for the difference in policy outlook between the ECB and the Fed.
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