September Tapering and the US Dollar

[tradingwizzard 10]

More than one big investment houses are calling now for the Fed starting to taper the quantitative easing program as early as the coming September. While this may be true, the real question will be how will the markets and the US dollar react to such a thing and is the reaction (if any) going to be too violent? To the surprise of many, it may pass as a non event. And here is the logic behind.

 

Current pace of the quantitative easing program is 85 bln on a monthly basis, and the original thinking was to keep it running as long as unemployment rate is higher than 6.5%. However, what would you do if the unemployment rate comes down to, let's say, 6.8% and stubbornly stays there. Would you inject the same amount on a monthly basis? Definitely not, and this is where tapering comes into discussion.

 

The NFP report this week was showing twelve consecutive monthly readings +100k, not seen since 1999-2000. This would only give justice, to those in favor of the quantitative easing program, as this program was criticized since inception on a world wide basis. Even some Fed members were not favoring it from the beginning, but this positive print streak the NFP report shows has the power to suggest the program was not off track. So what would a tapering in September will mean and how markets will react to the removing of stimulus?

 

First of all, it depends very much on the amount we are talking about. There are rumors on the market about 20 bln to start the tapering (10 bln for Tsys and 10 for MBS), but this are only rumors. Market chatter however has the tendency to be in line with expectations most of the times so I would not rule out such a move. That would make the Fed still to pump 65 bln on a monthly basis and this is still quite an amount.

 

Second, how will the Fed react if after starting to gradually remove the stimulus, the unemployment rate starts to rise again? Will they increase the size again? I mean, if it worked once, why not work the second time? This is the big problem from my point of view as it shows a weak US economy which is not able to stand on its feet without the Fed to provide help, and that would be disruptive to the markets.

 

Moreover, think about the fact that what the US started with engaging in this quantitative easing program has been copy/paste all over the world: UK is calling it asset purchasing facility, in Japan we all know what is happening (they are running twice a bigger quantitative easing program as in the US, on an economy three times smaller), and even Europe is engaged in this rush to ease as much as possible (what do you think all these bailouts mean?). So what the Fed will do to exit the program and how the economy will react is going to be watched by the whole world.

 

Only the discussion of the possible tapering in September made traders/investors to run into the US dollar and the reasoning was not related to the size of the tapering, but what the move actually means, creating a precedent. However, I would be cautious jumping on the long side just that easy as a stronger US dollar brings back problems US forgot it had in the past. And 65 bln dollar on a monthly basis still means easing, quite a lot by my standards.