When will the Fed start tapering?

Market volatility over the past few weeks has put a spotlight on the immense challenges facing the Federal Reserve’s exit from quantitative easing. The question is, will they taper bond buying or not?

Read: Will U.S. Fed stimulus taper off?

Since the beginning of the year, part of the Fed’s official discussion has been about how to withdraw from its ‘great liquidity experiment.’ In January, several FOMC members indicated they were already looking ahead to an exit, even though the market was preoccupied with fiscal cliff and sequestration issues.

Since mid-May, the talk of tapering open-ended quantitative easing has heated up, captivating the attention of investors across the globe. In May, the Fed affirmed that they will continue to purchase securities on a medium-term basis, but they did not indicate how much or for how long. As they try to be transparent in disclosing their adjustments, investors are left to decipher what is meant by “substantial improvements in labor market conditions.”

Hence the recent stir in volatility for both fixed income and equity pricing. Following the strong April employment report, the yield on U.S. 10-year Treasury bond has risen by 50 basis points, from the low starting point of only 1.66%. But has the rise in yields overshot the economy’s strength?

While non-farm payroll growth of 175,000 in May was marginally stronger than expectations, the three month average pace of job creation (+155,000) is currently at the lowest level seen since October of last year, right after the Fed introduced QE3. Under current lackluster economic conditions, it could be argued that no tapering is warranted until the data shows the economy and sentiment are stronger.

Read: QE pullback could end equity run

We don’t see a significant “tapering” of QE until first quarter 2014, at the earliest. The Fed has set and maintained accommodative policy in support of financial asset price appreciation. We’ve reached an inflection point where investors are just now starting to grapple with what implications a slight reduction in non-conventional monetary accommodation could have. We suspect the Fed’s current level of accommodation will last longer than the markets believe, but as with any imminent change in direction, higher volatility can be expected for the next few months.

EMPLOYMENT CONTINUES TO IMPROVE

Fewer Americans than forecasted filed applications for unemployment benefits last week. Could this be a sign that even as growth cools, companies are refraining from firing workers?

The market was expecting weekly claims to be 346K, but the actual reading came in at 334K. Although it was still higher than the reading on May 3rd, it was the third lowest reading since the fallout from the financial crisis. Most economic indicators of late have been a touch weaker than expected, but initial jobless claims continue to be a bright spot.

Despite this, there’s still a sense of gloom in terms of the perception of employment conditions. Companies have pared about as much staff as they can so employers are in a position to add to headcounts should their sales improve in the second half of this year. We saw retail sales increase more than forecast in May, meaning recent job gains and lower borrowing costs are encouraging consumers to spend. The 0.6% increase in retail sales was the biggest jump in three months and followed a 0.1% April gain.

TRADING WEEK AHEAD

Markets have been so hypnotized by Fed taper talk and Bank of Japan stimulus speculation that it’s hard to see how that will change next week. The main focus will be the FOMC meeting on Tuesday and Wednesday.

The recent economic data confirms a modest slow-go economy so look for the Fed’s policy language to calm recent market anxiety.

Tuesday’s CPI/Core CPI may be one reason the Fed will wait before tapering its QE3. The May CPI report should show both CPI and core CPI registering benign 0.1%. Also on Tuesday, U.S. Housing Starts should show signs of bouncing back in May.

Read: Toronto condo market risk to economy: BoC

Thursday’s U.S. Existing Home Sales should edge up slightly in May to the highest reading since November 2009. We expect an improvement because pending home sales rose 1.8% over the past two months. Pending home sales lead existing home sales by a month or two. Tight credit conditions and limited inventory continue to constrain sales, but home buying and home selling conditions continue to point to improvement.

David Andrews is the Director, Investment Management & Research at Richardson GMP in Toronto. This team of research experts is responsible for monitoring and interpreting economic, geo-political situations, current market environments and trends. @David_RGMP