QE Tapering Preview: 5 Reasons And 6 Scenarios

 |  Includes: UDN, UUP
by: Yohay Elam

The Federal Reserve convenes for a highly anticipated meeting to make a decision about QE tapering. There is a very high probability that the Fed will announce a reduction in the pace of bond buying on September 18th, and probably by $10-15 billion to $70-75 billion.

Here are 5 reasons for the expected tapering and 6 scenarios for the decision and the all-important accompanying statement.

The statement and economic projections will be released at 18:00 GMT, and Bernanke will face the press at 18:30 GMT.

Five reasons why the Fed will taper

  1. Ongoing recovery: Despite the recent weak employment report, the US is still growing and creating jobs. Jobless claims are edging lower and PMIs show an intent to hire. This recovery isn't that strong, but at this point, the effectiveness of bond buying is limited in creating a "wealth effect" that Bernanke mentioned.
  2. Fear of inflating bubbles: Bernanke and co. can look at QE and see it as a success story in the housing market, with a clear recovery. However, with house prices rising around 12% YoY (Case Shiller), perhaps the time has come to reduce the level of stimulus (the Fed does not see tapering as tightening) to avoid blowing a bubble. In addition, the Fed might worry about other bubbles in stocks, commodities and emerging markets.
  3. Thick hints: The notion that the "Septaper" is coming is strengthened by recent comments from Fed officials, and that come with "an open mind" to tapering in September. This includes the doves. With the Syrian issue somewhat defused, there are very little chances that the Fed will not taper.
  4. Legacy: We now know that Summers will NOT inherit Bernanke. Even if Bernanke stays on the job and doesn't evacuate his chair for Janet Yellen, he would probably like to begin unwinding the biggest monetary stimulus in history and not leave it as a hot potato.
  5. Passing the ball to the government: the Fed would prefer that the government pick up the baton and address the sequester. They already criticized the government for lack of short term stimulus and talked about things that are out of their realm.

All this leads to the conclusion that tapering will be announced on September 18th.

Six scenarios and USD reactions

This is a big shift in policy as it is the beginning of the end of QE, the beginning of the end of printing dollars, and a positive for the dollar and negative for bonds, commodities and stocks.

QE tapering is not fully priced in, and we could see the dollar strengthening afterwards. A lot depends on the guidance to the next tapering steps, and this remains a mystery for now.

Here are the scenarios, starting from the more probable ones to the less probable ones:

  1. $10 billion tapering and intent to end QE in mid 2014: This scenario has the highest chances: a relatively symbolic reduction of QE would send a message of a shift in policy, but is a cautious move that leaves the door open to a slow and gradual process. Sticking with an intent (not a commitment) to end QE by mid-2014 would be a repetition of what Bernanke said in June. This scenario is almost priced in: the dollar would strengthen, but in a limited manner.
  2. $15 billion tapering and intent to end QE in mid 2014: This scenario also has a good chance but would be more dollar positive as it reaches the higher end of expectations.
  3. $10 billion tapering and no future hints: In this scenario, tapering would be seen as a very cautious and perhaps only symbolic move, but without any quick follow through to end QE, an initial move that will be very carefully assessed afterwards. Such a decision would significantly weaken the dollar and strengthen stocks, as it could be perceived that the easy money will continue flowing. Chances are lower.
  4. $15 billion tapering and no future hints: This has somewhat lower chances, and will leave markets somewhat confused, but tapering at the higher range could slightly help the dollar.
  5. $20-25 billion tapering: A more significant tapering cannot be ruled out, as the total monthly buys stands at $85 billion, and the timetable until mid 2014 is not that long. In this hawkish scenario, the dollar would soar as it is beyond the consensus. The scenario has little chances.
  6. No tapering: Given recent worries from retail sales and jobs, also this scenario cannot be ruled out. Tapering could wait for one of the two remaining meetings until year end. A cautious approach by the Fed would send the dollar sinking as markets are expecting tapering. Given all the hints, this scenario has low probability.

That's it. What do you think? Will the Fed taper? How much is already priced in? Where will currencies be at the end of the week?

It's important to remember that the initial reaction to FOMC statements is not necessarily the long lasting one. The full effect can sometimes be assessed only in the US session the following day.

Further reading: Fed tapering could trigger new financial crisis

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.