Markets’ Tapering Reaction Caught Up in Year-End Positioning

After yesterday’s post-FOMC volatility, and eventual dollar gains, a consolidative tone has emerged in holiday-thin trading.  In fact, it is difficult to separate the year-end positioning adjustments with the response to the Fed’s tapering.

The Fed coupled with small $10 bln tapering announcement with a stronger forward guidance, though shied away from the more bold moves that had been previously discussed, such as a cut in interest on excess reserves or lowering the unemployment threshold.  Still, the indication that rates will likely not be hiked until well past the 6.5% current unemployment threshold is understood to be almost tantamount to 6.0%, with the firm commitment.

The other way the FOMC strengthened its forward guidance was to seemingly upgrade its concern about the low inflation, which it says it will be monitoring developments closely.  While one would expect the Fed to have been doing this all along, the wording in the statement would seem to emphasize this concern.

We had not thought tapering was likely and that forward guidance would most effectively be delivered by the next Fed chair.  Despite being wrong on the decision, it still seems that Yellen’s credibility has been compromised.  She is still seen by many as a “super-dove” and, in fact, there was some immediate speculation that Yellen was the FOMC member who shifted her view to no rate hike until 2016, where she ostensibly joined 2 other of her 17 colleagues.  A dozen of the 17 see the first hike in 2015.  In September, three had thought a hike in 2014, but now there are only two.

Here the Fed’s forecasts underscore the forward guidance, but economic forecast changes are more mixed.  While the range of next year’s GDP widened slightly in both directions, the upper end of the forecasts for 2015 and 2016 were trimmed.  Unemployment forecasts were mostly lowered by 0.1% across the board.  The core PCE deflator forecasts were tweaked with the lower end of the range easing but the upper end not.  The Fed does not expect core PCE deflator to be above 2% through 2016.

Asian equity markets as  a whole struggled to follow the lead of US markets.  Though the Nikkei gained 1.75%, the MSCI Asia-Pacific Index was up less than 0.2%, weighed down by losses in HK, China and India.  On the other hand the MSCI Emerging Markets Index is up almost 1.4% near midday in London and South Korea, the Philippines and Taiwan reported net foreign purchases of their equities today.  ]

European equities are rallying.  The Dow Jones Stoxx 600 is up about 1.4%, nearly matching yesterday’s 1.65% gain in the S&P 500.  Although the euro area reported a 50% jump in its current account surplus (to 21.88 bln euros from 14.9 bln in Sept), the euro is consolidating yesterday’s late losses.  In Asia, it initially extended the drop to $1.3650. briefly slipping below the 20-day moving average for the first time in about four weeks (~$1.3660).   The reversal from the $1.3800 area yesterday reinforces ideas of this being an important near-term cap.  Good selling from longer-term participants was reported there.   We suspect some short-term participants may be trapped and anticipate them selling on a bounce toward $1.3730.

The European Summit has not begun in earnest yet and already the agreement on the single resolution mechanism is largely being seen as too complicated to be timely and too miserly to be very useful.  The bank funded backstop will take a decade to reach its full force of 55 bln euros, which would be a laughable amount if it were not so serious.  In the mean time, the funding must be provided on the national level, preserving the link between the sovereign and banks, which was hoped to have been severed.

Moreover, the complicated decision making process from identifying a troubled bank to shutting it down could take as many as 100 votes, with some decision a double majority (2/3 of the countries and members that represent at least 50% of the funding, which prevents the majority of debtors ganging up on the fewer creditors).

Germany seems to have come out ahead in this compromise formation.  There is no new public-funded backstop.  Finance ministers, rather than the EC ultimately decide whether a bank is shuttered.  The Single Resolution Board, where Brussels is represented, makes recommendations.     The link between banks and sovereigns, that has been dubbed the “doom-loop” by some is important for Germany to maintain if it want to preserve the other link between sovereignty and solvency.

Countries that need to tap the ESM to help it fund bank recapitalization programs has to sign on to agreements that are tantamount to surrendering some aspects of sovereignty.  This is the fountain from which structural reforms spring.  It is also consistent with efforts to protect German tax payers from having to bear the cost of recapitalizing poorly supervised foreign banks.

Separately, the UK reported largely as expected November retail sales.  The 0.3% rise in the headline rate was in line with the consensus, but the October series was revised down to -0.9% from -0.7%.  Excluding autos, retail sales rose 0.4%, slightly stronger than expected.  Sterling was barely changed, though has slipped near midday in London.  In the post-Fed market, sterling has fared better than the euro, though the FTSE and gilts are under-performing.

The dollar-bloc continues to trade heavily.  Slightly higher on the day, the Australian dollar is the firmest, though remains near three-year lows.  The New Zealand dollar is lower, ostensibly on profit-taking despite reporting the first Nov trade surplus since 1991.  The US dollar is trying to establish a foot hold above the CAD1.07 level.  In the first half of 2014,  we expect the Canadian dollar to under-perform.

In increasingly illiquid market conditions, the US reports weekly jobless claims, the Dec Philly Fed survey and existing home sales.

This piece is cross-posted from Marc to Market with permission.