A Mild Hawkish Change? 4 Scenarios For The Fed Decision

by: Yohay Elam

Will the Fed hint at a future reduction of bond buys? This is the main question for the highly anticipated statement that will be released by the FOMC. Speculation about such a move has had a tremendous impact on stocks, commodities and the US dollar.

It is important to remember that tapering does not mean tightening - it only means that the Fed will buy less than the current $85 billion of treasuries and MBS. The balance sheet will still expand. Nevertheless, seeing a change in the near future will be considered tightening, and is expected to have a negative impact on stocks and commodities, and a positive impact on the dollar.

What does the market expect?

At first, tapering seemed closer: the Fed's Williams, a known dove, talked about tapering in the summer. Ben Bernanke opened the door to tapering in one of the "next few meetings" (despite a generally dovish statement) and markets certainly got ahead of themselves. An improving US economy in a "self sustained recovery" allows the Fed to loosen some of the loose policy and begin preparing for a future exit.

However, some mediocre to weak data poured in later on: PMIs showed weakness, consumer sentiment fell from the highs and jobless claims didn't stick to the low levels. Expectations fell and so did the dollar. Tapering seemed far.

The most recent Non-Farm Payrolls report gave a little bit for everybody: job gains of 175K, in line with the average of previous months, but below the 200K level that is thought to be the Fed's objective.

All in all, expectations for tapering are lower.

What can the Fed do?

This is the key line from the previous statement, from May 1st:

The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.

This was different from the March 20th statement:

In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives

Here are 4 possible scenarios. from the most dovish to the most hawkish:

  1. No change in the critical line: If the Fed leaves the current wording unchanged and expresses worries about the economy, the greenback will likely fall across the board. This will serve as a sign that tapering is far away, perhaps only in 2014. This scenario has a low probability.
  2. Slight hawkish change: The FOMC could go back to the previous, more general nature of the March 20th statement. As the change on May 1st sounded somewhat dovish, a change back to the previous wording, or something similar, would be considered marginally hawkish. The dollar could react with a small rise. This scenario has a relatively high probability. It will serve as a hint to tapering late in the year.
  3. Hawkish change: The recent statement left the door open to changes in both directions: the reduction (tapering) as well as the increase (un-tapering if you wish). A change to something along the lines of "… prepared to reduce the pace of its purchases if the economy continues improving…" - this would be a declaration of intent to taper. The result would be a stronger dollar. This scenario has a lower probability, and is not priced by the markets. It will point to tapering in September with a possible end to QE at the end of 2013.
  4. Announcement of tapering: If the Fed announces an immediate tapering of bond buys to a scale of $65 or even if it only scales down to $75 billion, the dollar will leap. This scenario, which seems to have very low probability, is not priced by the markets. It will point to an end to QE, perhaps even before the end of the year.

Needless to say, every future decision will be based on incoming data and not only on intentions hinted in this statement. Speculation about the next moves will continue to rock the financial markets during the summer. Every Fed official and every indicator will be watched.

What do you think will happen? Where will the dollar be after the decision?

The decision will be announced on Wednesday, June 19th, at 18:00 GMT. It will be accompanied by the FOMC Economic Projections and will be followed by a press conference by Ben Bernanke at 18:30 GMT.

More: QE tapering: June might be too early to adjust the statement [Simon Smith]

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.