Facing up to the Fed's moment of truth

FOMC members are agreed on what needs to be done, it’s just a matter of deciding when and how hard to pull back. Despite market protestations, a shift will come very soon.

The minutes of the recent US Federal Open Market Committee meeting on July 30 and 31 confirmed a couple of important issues that remain confronting for financial markets.

These are that the US economic recovery is real and sustainable, even if it is not a particularly strong one, and that as a result, the super-stimulatory monetary policy currently being prescribed by the Federal Reserve needs to be wound back some time starting soon. 

The markets are having anticipatory withdrawal symptoms about the prospect of an end to the Fed buying bonds (quantitative easing). US stocks were particularly volatile overnight, lurching lower in reaction to the minutes, then jumping higher as the market assessed and reassessed what the Fed was talking about and what it might actually do. 

US stocks ended the day around 0.5 per cent lower on average, having been down close to 1 per cent just after the minutes were published. The stock market rebounded to about square around an hour before the close, before fading at the end in what was particularly choppy trade. The 10-year government bond yields were more sure in their outlook, with the yield spiking to 2.88 per cent.

The FOMC noted a number of critical points. 

It was “broadly comfortable” with the plan outlined by chairman Ben Bernanke to reduce the level of bond buying but said that “almost all committee members agreed that a change in the purchase program was not yet appropriate” – although “it might soon be time to slow somewhat the pace of purchases as outlined in the plan”.

In other words, the FOMC would like to start the process of scaling back quantitative easing, but it needs to tread carefully given the below-par economic recovery being witnessed in the current cycle.

On the positive side, the FOMC noted that the unemployment rate, which is at a five-year low of 7.4 per cent, had declined “considerably”. It also expected the economy to “strengthen further” over the second half of 2013, driven by more gains in housing and consumer spending.

With this outlook for the economy, the FOMC noted that it would need to start the process of ending QE, although the timeline for such action was open to discussion.

According to the minutes: “A few members emphasised the importance of being patient and evaluating additional information on the economy before deciding on any changes to the pace of asset purchases.”

The more dovish members of the Fed expressed concern about the sharp rise in bond yields in recent months, noting that overall financial market conditions had tightened significantly and that “they expressed concern that the higher level of longer-term interest rates could be a significant factor holding back spending and economic growth”.

The more hawkish members dismissed that concern, noting that the recent rise in bond yields, for example, “was likely to exert relatively little restraint”. The minutes showed that the hawkish members even suggested the bear market for bonds was desirable as it was likely to include “an unwinding of unsustainable speculative positions".

Clearly, everyone who has a say within the Fed knows what needs to be done. The questions are, when to start and how hard to go?

While there is no firm consensus view from the market on this, it appears that the current program, which has the Fed buying $US85 billion ($93.6 billion) of bonds per month, might be scaled back by $US10 billion a month or so – possibly starting next month, but if not then, in October.

Turning points in policy are never easy to forecast. They can be disrupted by the market reaction to how the new policy direction is felt in the market, and perhaps more importantly in the real economy.

In the US, the proposed policy tightening in this cycle will be no different. To work, it will need the underlying strength of the economy to be sustained. And for the market, a period of flat to rising share prices and moderate increases in bond yields will be something that will allow the Fed to negotiate the taper of its bond buying program.