The Fed’s QE program remains in the spotlight as investors try to size up when the central bank will start trimming the size of its monthly bond purchases. This week’s busy economic calendar, particularly the May Jobs report coming out Friday, is particularly significant for Fed watchers as they would set the tone for this month’s FOMC meeting. This morning’s modestly narrower trade deficit isn't that material to the QE question, but Monday’s weak ISM read was interpreted as delaying the ‘taper’ announcement and supposedly market friendly.
In the market’s black and white framework, ‘taper’ is bad and everything that delays it is good. But does such an oversimplified framework make sense? Yes, it does and here is why.
The markets understand that 'taper' doesn't mean an immediate end to the Fed's easy-money policy. But given their inherent forward-looking bias, they can't help but to interpret the move as the beginning of the end. As a result, the mere 'taper' announcement prompts the bond market to start looking ahead to the time when the Fed will stop all bond purchases altogether. Nobody expects the Fed to start selling bonds from its portfolio, but once they stop replacing maturing bonds, their balance sheet will start shrinking as well. What this means is that the 'taper' announcement is in effect a major change in monetary policy.
The Fed's traditional role gave it plenty of power over the shorter end of the yield curve through the Fed Funds rate, but it never had much direct influence over long-term interest rates. This changed with the various QE programs when they literally purchased such influence by becoming a major player in the bond market. The 'taper' and subsequent decisions can, in a way, be seen as an end to that influence and ‘freedom’ for the bond market. The stock market is justified to be wary of a 'free' bond market.
But can the Fed afford to let the bond market become ‘free’ and push rates to levels where they actually belong? My sense is that they can't afford to let that happen. I would expect them to have some red lines or target yield levels that they don't want the bond market to get to. They obviously can't publicly announce those target levels, but they would like the bond market to appreciate that they stood ready to come back in full force if needed.
Not an easy communication strategy to pull off, but then nothing that the Fed does is easy or straight forward. In the end, it all comes down to the Fed’s credibility with the markets.
Source: Zacks
