QE Scale Back: Fed Should Time It Right For Its Success

Includes: DIA, GLD, IEF, SPY, UUP
by: Fx Stocks Data

The much anticipated June payroll figures have been excellent, with a gain of 195,000 jobs in June and a revision of April and May jobs to 199,000 and 196,000 respectively. Suddenly, the U.S. employment has started to appear particularly strong, weathering the fiscal concerns and higher taxes, with the past 3 months' average figures close to 200,000. The unemployment rate, however, remains unchanged at 7.6%. Following the data release on Friday, the U.S. stock market rose sharply on the news with S&P 500 gaining 1% to close at 1,631.89 while the Dow Jones Industrial Average added 1% to close at 15,131.89. The 10-year Treasury yield jumped 10bp from 2.56% to 2.66%, reaching its highest level since August 2011. The U.S. dollar hit a 3 year high with USD/JPY hitting 101 and EUR/USD made its way towards 1.28. The stocks remained volatile through the day on Friday, with investors weighing the improving job numbers against Fed's possible stimulus scale back worries. The Fed chairman Ben Bernanke during the last month's FOMC meeting, indicated "the central bank is considering scaling back the on-going $85 billion a month asset purchase program later this year." Ever since the Fed launched the QE3 stimulus program during last September, the investors had been on an aggressive stock buying spree, which continued through the majority of the first half of 2013, when the major indices reached record levels on May 22nd 2013; with Dow index touching 15542 points while the S&P 500 at 1687. Since then, the rumors of the Fed strategizing the stimulus exit had created enormous volatility in the market, which continued to gather strength, when the Fed eventually confirmed during the FOMC meeting that it indeed would "scale back the on-going stimulus later this year." The investors reacted sharply to this shocker by the Fed, and most opted to take the profits and stay out of the market as the month of June remained very volatile for the stock and the bond markets, with the treasury yields on the rise. The investors long awaited the June non-farm payroll figures, to foresee any possibility that the Fed would delay its tapering plans.

Although the job numbers are good, everything is still not right with the U.S. economy. While the employment figures have been exceptional, the percentage unemployment level of 7.6 % is still very much a worrying factor. For the years 2007 and 2008, the average unemployment was around 5% as compared to the current levels of 7.6%. Although the employment rates have come down from its highest levels of 10%, recorded during October 2009, the inconsistent labor participation rates have distorted the figures. According to the Bureau of Labor Statistics, "the number of unemployed persons, at 11.8 million, and the unemployment rate at 7.6 percent remain unchanged in June. Both measures have shown little change since February." This is a serious concern as no matter how much progress was made with regards to the increase in the job numbers, more labor participation rate pouring in each month has prevented the rates to come down, as quickly as expected. The Federal Reserve cannot overlook this figure and start scaling back before they could bring this down to below 7% with some consistency, in order to stabilize it. The labor participation rose to 63.5% from 63.3% earlier in the year, the lowest level since 1979. This is likely to make things difficult for the Fed to forecast the speed at which the unemployment rate may come down to an acceptable level; i.e. up to 7%, to rightly time the stimulus cuts.

The Fed must ensure the U.S. GDP, which disappointed in the first quarter of 2013 (revising down to 1.8% from 2.4%), moves up quite considerably at least the next couple of quarters, before taking any drastic steps on scaling the $85 billion monthly asset purchase program. The GDP must grow close to 2% for the year so the growth could be sustained when the scale back of the stimulus occurs. The last time we saw a GDP of 2% or above was in 2005. The Federal Reserve's money pumping into the economy had the effect of masking the $85.4 billion cuts in government spending, so far for 2013. With similar cuts to follow in 2014 through 2021, taking away the monetary support might result in the actual realization of the impacts of these cuts, which could have adverse effects on the overall growth of the economy. With a rate rise looming, the bond market and the housing market are the other two key areas which could be impacted severely. Ever since the recession started in 2008, the Fed has pumped in more than $1 trillion into the Treasury Securities. Any withdrawal of these funds could result in higher yields and falling bond prices, with the investors suffering huge losses. On the other hand, the $40 billion a month stimulus money being used to purchase the mortgage backed securities helped in lowering the mortgage rates, to improve the housing demand. If the stimulus is scaled back or withdrawn sooner, the mortgage rates will go up sharply, threatening the recovery made so far.

The repercussions of the monetary tightening in the U.S. will be greatly felt in the eurozone, and this was quite evident when the German DAX tumbled by 2.36%, upon the release of Friday's Payroll data, anticipating the solid job numbers will force the Fed to unwind the on-going stimulus sooner. The European central bank during the policy meeting last Thursday issued a forward guidance policy and promised to "keep the interest rates low for an extended period of time," also assuring an "accommodative monetary policy, for as long as necessary." The ECB stressed to rely on their "two pillar strategy" oriented policy in achieving price stability, striking a balance between inflation and monetary dynamics. The latest political crisis in Portugal sends a reminder that the eurozone crisis is far from over. Even after the fiercest austerity drive in Portugal, the economy remains weak with the unemployment levels soaring at 17.6%. The political uncertainty has threatened to upset the progress of the country's €78 billion bailout program. Greece, on the other hand, has been failing to meet critical deadlines to qualify for a €8billion (£6.9 billion) tranche of bailout money. More worrying is the fact that Germany's own economy is hardly booming, with unemployment levels yet to pick up convincingly and the country's factory orders falling short for a second straight month in May, dropping 1.3%. Economists had expected growth out of Germany's industrial sector, and the unexpected fall is a sign that the on-going eurozone crisis is disrupting the recovery in the Europe's largest economy. The OECD forecast the eurozone economy "will shrink by 0.6% this year." With Germany, getting ready for the elections in September, the eurozone political uncertainty coupled with the looming U.S. monetary tightening could dent the confidence of the 17 nation bloc and may potentially lead to a further deepening crisis within the eurozone, which in turn may have grave impacts on the U.S. growth.

With the strengthening of the U.S. dollar, the currency depreciation and inflationary pressure will be a significant concern for the emerging markets which in turn could dent the global growth. China slowdown is another major concern for the U.S. as the growth in the second largest economy fell short of analyst expectations. According to a Bloomberg survey, "the ongoing credit crunch will reduce the credit growth by 750 billion yuan ($12 billion), an amount equivalent to the size of Vietnam's economy." Given both the Bank of Japan and Bank of England, is also persistently pursuing quantitative easing, the Fed should ideally take the global factor into consideration, before making any brave moves.

The important question to ask is whether the U.S. economy can handle the reduction in stimulus later this year. Although I'm a firm believer that the real economic growth can only be realized once we move out of the stimulus, the timing of the exit remains very critical. Even though the Federal Reserve has convinced the markets that the scale back would still mean the Fed continuing with the monetary support, albeit on a lower stimulus, the central factor remains how well the Fed could anticipate what's going on within, as well as outside the U.S. The success of the unwinding also depends on how flexible the Fed remains on reversing the cuts if the economic conditions worsen due to lack of sufficient liquidity. We should also not forget any sovereign defaults could be withstood only if the economy is strong enough to handle it. So the Fed would be eager to test if the U.S. can withstand stimulus cut down and absorb peripheral shocks if any, by opting only a minor cut initially - whenever they opt to implement it. The Fed should also anticipate the nature of the assets involved in the taper, i.e. whether the Treasuries or Mortgage Backed Securities or a combination of two and how to pace it to strike the right balance. Any mistake in strategy and timing will have lasting effects on the economy. The stock market correction is inevitable during the scaling back of the asset purchases, which is fine. But there is a fine line between retaining the confidence among investors and creating a total panic, which could effectively jeopardize the economic growth.

As for the investors, the upcoming Fed minutes due to be released this week are quite significant, to figure out if the Fed committee members have laid out any further hints, as to what the timeline is for the stimulus scale down. If there are any clues on a possible stimulus cut, then the investors need to exercise caution and expect a volatile trading ahead.

The trading strategy to counteract this situation should be as below:

-The U.S. dollar will rule the asset classes and will continue to gain. So buying up on the dollar will be a good strategy for the medium term.

-Opt for short dated bonds than longer dated ones, since the stimulus withdrawal could raise the long dated treasury rates, further deteriorating their value.

-Short gold, silver and other precious metals for now, as the prices may deteriorate further, given the Fed uncertainty over the on-going stimulus.

-Stock markets will remain volatile, thanks to the Fed uncertainty and the solid job reports. Any gains could be limited as investors await the next move from the Fed, so buying only on dips is recommended for the short term.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.