FOMC Meeting Preview

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The Expected Scenario:

– No tapering of QE in December, but a strong signal by the Committee that tapering of QE will happen in January or March.

– Tapering Logistics:  If asked about how tapering will work, the market expects to see an initial tapering of $10 billion-$15 billion, and the process to be linear (tapering the same amount each month or quarter, whichever they decide).  And, markets expect the first taper to be weighted toward Treasuries, while mortgage-backed securities are left alone (to help soften the blow on the mortgage market, although I’m not sure it’ll make much of a difference).

If this is what we get Thursday, don’t expect any significant, volatile reactions from the various asset classes, as again this is what’s priced in.  As far as how markets will trade beyond the immediate reaction, that’s a tough one to call.  We could either see a “sell the taper rumor/buy the taper news” reaction. Or we could see markets drop on the news, due as much to the calendar and the skittishness of money managers I’ve been talking about, given the gains so far this year.

Regardless of the short-term reaction, I don’t think this expected scenario really alters the market dynamic beyond the short term, as long as the short end of the yield curve stays buoyant (SHY).  So, point being, I still think the path of least resistance would remain higher beyond the very short term if this is how the meeting goes.

The “Hawkish” Scenario:

  • The Fed tapers QE in December –or—
  • The Fed doesn’t taper in December but strongly implies the first taper will be beyond the anticipated $15 billion (say $20 billion-$25 billion).

This would get a hawkish (and negative) response from markets, and you’d see bonds spike lower, gold sell off hard and equities decline as well (the only thing that would go up would be the Dollar Index).  Short-term sell-off aside (and there would be one), it would remain to be seen how “bad” this would be for markets over the medium term.  The keys to watch would be SHY (short-term Treasuries), and PCY and EMB (emerging market bond ETFs).  If they all went into freefall, it would be a major negative for stocks.  If they stabilized after an initial dip, then the “hawkish” tone might not mean decidedly lower equity prices.

The “Dovish” Scenario:

  • The Fed pulls a “September” and doesn’t taper, nor does it give the impression that tapering is imminent.

This would elicit a “dovish” response from the markets, as bonds would rally, gold would see a big jump given the number of shorts in the market, and the dollar would drop.  The surprise in this scenario, though, would be that equity prices would likely fall (and personally, I think this outcome would be the worst for risk assets).

Stocks would drop for two important reasons:  First, tapering isn’t really viewed as a major positive anymore, and the market would much prefer to get the economy back to normal with no tapering.  If the Fed can’t taper with improving economic data and clarity in Washington, the idea that the Fed is “trapped” in QE will start to get legs, and that implies the Fed has lost control.  Second, the market again would have gotten the Fed totally “wrong” and I think this communication breakdown would start to weigh on risk assets, as it would become clear that the market can no longer read the Fed, thus introducing significant macroeconomic uncertainty.

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