FOMC Preview: Tamping Down the Taper Talks

Summary

• 2021 sees a more dovish FOMC voter block, yet the tone at the year’s first meeting should deviate little from the last meeting’s neutral messaging.
• All the action will be at Chair Powell’s press conference given that this meeting will see no release of new economic or rate forecast projections.
• Expect a tamping down of the taper talk as the Fed will want to use forward guidance for the QE exit narrative and have as long of a runway as possible.

Market Implications

• Although the economy should be turning the corner into late spring/early summer, a soft patch and potential risk-off moves will help duration trades.
• And long-end rates have moved high enough now that buying dips or entering into 10s30s flatteners for the next few weeks makes sense.

It’s a New Year, but the Fed Is Still Dealing with Last Year’s Problems

The economy is in a much better place now versus the peak shock after the coronavirus lockdowns in early 2020. But still, renewed lockdowns, although more targeted in nature, will likely dampen the recovery for some time yet. The recently passed stimulus in December will provide a much-needed boost. But given how long it took to get in place, there has been some damage done to aggregate demand and household confidence coming into the first quarter of 2021. This calls for continued caution, for now.

That said, the Fed must balance this near-term drag on growth, and the bumps on the road to recovery, with an open mind given that a ton of fiscal stimulus was put into the system (with the prospect of more being thrown in for good measure). That, along with ongoing Fed easing, has primed the pump for a potentially very strong 2H21. In addition, the vaccine rollouts are picking up steam, and herd immunity might not be far off. So, let’s say it’s time to be cautiously optimistic.

What to Expect at the Meeting: Its Dovish vs Neutral (Hawkish risks are for 2Q+)

First, we look at the dovish side. There is a more dovish voter block, and there are concerns that some of the recent taper talks by several Fed presidents have helped push up long-term rates and risk premia. Consequently, this new FOMC may encourage the chair to really push back on premature taper talks. Such actions would be mostly symbolic, though. Most bond market participants are not expecting tapering to start until well into 2022. And even the most ardent hawks (in a world of unending easing, those expecting less easing are now the hawks) see a gradual reduction potentially starting in late 2021. Beyond the QE tweaks, the chair can suggest some time windows associated with when the average inflation target needs to remains above 2% as a driver of their taper policy.

Now to the more neutral side, which is my base case. Chair Powell will come across as cautiously optimistic that the building blocks for a sustained recovery (one that might actually be quite strong in the second half) are in place. All we need is to get through this winter and the vaccine rollouts. Even in this scenario, the chair will push back on taper expectations. But he will be more balanced versus constantly repeating last year that they are not ‘even thinking about thinking about’ slowing down easing. The chair is getting what he wanted in terms of fiscal easing as well, so that should at a minimum give them confidence in their economic outlook ahead. And let’s watch for any mention on supply disruption vs service inflation, too. If there has ever been a time for two-way CPI risk, it’s now.

Conclusion

The Fed is fearful of a ‘taper tantrum 2.0’ given how many financial markets are trading at the most extreme valuations or tightest spreads in recent history. This easing of financial conditions has been one key driver of keeping the wealth effect channel in place. Now the fiscal side is giving another boost for the economy to get it hopefully on a sustainable path. Meanwhile we highly doubt the Fed of all central banks will follow recent hawkish turns by other CBs around the world, let’s not forget the Fed eases conditions for all areas. Thus, it is pointless to rock the boat at this meeting and come off too strongly in one direction or another.

That said, there is a risk that President Biden’s stimulus plan comes in smaller once there is a proper debate in DC. We do not expect a policy error delay like we saw with the second round of stimulus, which happened only after the election. But there is still potential that any short-changed fiscal stimulus hopes will result in risk markets reversing this train of unending all-time highs. This should help trigger some long duration trades in the very short run, in my view.

In many ways, the 2013 taper tantrum was a setback for the Fed and a rude awakening to how tied markets are to their easing stance. In my view, the 2013 volatility likely pushed back the exit strategy for the Fed back then too. The better they can control the QE slowdown process this time, the more smoothly they could progress eventually to normalizing policy further in a couple years. That is future business, but the bond market clearly has been listening, although in a begrudged way, and is slowly pushing up rates. So, it will be a delicate dance.

I have been short duration and recommending steepeners since early September. But I recently I have turned neutral on duration after seeing signs of exhaustion in the rates market (as seen by the 63-day z-score of the 10-year). I think that at a minimum coming out of the Fed and upcoming supply, US 30s will outperform.

As Chart 1 shows, there have been several occasions when rates have seen a reversal higher to eventually stall given the magnitude of a recent move. The first was during the euro crisis 1.0 in the earlier part of the last decade. The second was coming out of 2016 with Brexit and the US election reflation dream period. Longer-term rates should keep grinding up as things improve, but a consolidation and a micro rally is doable on any negative outcomes and risk market reversal.