Last week’s bipartisan US budget compromise has somewhat increased the chances of an imminent reduction of the Federal Reserve’s monthly bond purchases. Against the background of relatively robust economic data and buoyant stock markets in recent weeks, the Fed could be inclined to seize the moment to launch the potentially uncomfortable "taper". Below we explain the arguments that might lead the Fed to surprise us later today.
Consensus does not expect a Fed taper this week
The US central bank will later today announce its latest monetary policy decision. The economist consensus expects the Fed to leave its asset purchase program unchanged – i.e. to continue its monthly purchases of $40 billion of mortgage-backed bonds and $45 billion of government bonds. We agree with the consensus, and had explained our reasoning on this matter last month in the LGT Beacon. However, the proportion of market participants that expect a Fed taper tomorrow has increased significantly in recent days, and we use the opportunity to focus on the main arguments that would speak for such a decision.
1. Budget compromise softens austerity and removes fiscal uncertainties
Republican and Democrat negotiators last week agreed on a budget for the next two fiscal years and both Houses of Congress have already approved it with strong majorities. The budget deal modestly softens fiscal austerity through October 2015. Furthermore, the strong backing it received even in the Republican-dominated House of Representatives potentially signals that the upcoming vote on increasing in the debt ceiling in February might not again degenerate into a noisy horse-trading circus. Thus, the bottom line of this development is that the outlook for the US economy is slightly more growth-friendly than the status quo ante.
2. US economic data relatively strong since the beginning of November
The US gross domestic product for the third quarter of 2013 was revised up rather significantly: quarterly growth was revised to 3.6% (seasonally-adjusted annualized rate), from an initial estimate of 2.8%, and 2.5% in the second quarter. At the same time, the Fed’s preferred inflation measures have also picked up. The gain in the core personal consumption expenditures index, which serves as the GDP deflator, has been slightly revised up from 1.4% to 1.5%, after only 0.6% in the previous quarter. The headline GDP price index’s annualized gain was raised from 1.9% to 2.0%, also up from just 0.6% in the previous quarter. In other words, these broad inflation indicators can be viewed as moving a little closer to the Fed price stability target.
Furthermore, the various leading indicators and purchasing manager surveys published since the start of November on balance point to a stronger-than-expected economy in the near future, while the US private sector continues to create about 200,000 jobs per month.
3. Issuance of US treasuries has almost halved following the decline in the budget deficit
The issuance of US government bonds, meanwhile, has decreased significantly due to a shrinking budget deficit. In the wake of the financial crisis, the US government from 2008 to 2012 was borrowing $120 billion per month on average, but that volume of new debt has dropped to an average of around $60 billion per month this year, after $100 billion last year - and it continues to decline gradually. Adjusting the Fed’s government bond purchases on the new, lower level of Treasury issuance could therefore make sense.
4. The financial markets are better prepared for a Fed taper
After countless discussions since May, which included violent stock market turmoil at times, long-term interest rates have in some cases risen significantly, while long-term inflation expectations have remained broadly stable. The markets could thus be now sufficiently prepared for a "tapering". Therefore, the Fed might come to the conclusion that the time has come to start the process of gradually normalizing monetary policy.
(Read more in the LGT Beacon: to download the publication, click on "LGT Beacon" below. To subsribe, click on "Abo".)