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FOMC preview: Taper timeline likely to be cut in half | Forexlive

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The final Federal Reserve decision of the year is here and it’s highly likely to include a hawkish move to speed the pace of the taper.

In August, the strong consensus in markets was a slow taper followed by a period of reflection and then slow rate hikes. Most were willing to follow the Fed in the belief that inflation would be transitory.

Since then it’s become increasingly clear that it’s not. Supply chain bottlenecks worsened rather than improving and the list of items rising in price broadened. On Tuesday, the producer price index — which measures input inflation — hit a record high at +9.6% year-over-year. CPI numbers have routinely beaten estimates and consumer inflation is now at the highest year-over-year level since 1982.

In that time, the Fed has performed a slow climbdown in its stance, eventually ‘retiring’ the term transitory — an admission that they were wrong.

In the crosshairs


Now Federal Reserve policymakers find themselves behind the curve and with a credibility deficit. The calls to hike rates are growing louder and so is the criticism. Former PIMCO CIO Mohammed El-Erian this week said the transitory forecast was the “worst inflation call in the history” of the Fed.

That’s some stinging criticism and unwarranted given the difficulty of navigating the pandemic. As omicron emerged in late November and the market rolled over, there was talk the Fed would pause the taper. Instead, Powell doubled down: He surprised markets by both retiring ‘transitory’ and said it would be appropriate to “talk about speeding up the taper” at this week’s meeting.

Since then, the market quickly priced into a doubling of the pace of the taper to $30B/month from $15B/month.

It’s important that there were caveats around that, particularly omicron, which he said they would know more about in the next 5-10 days.

Arguably, incoming information on omicron remains murky. Optimism about a far milder strain is fading and extremely high transmission rates have been confirmed.

However that won’t necessarily derail the Fed. The Bank of Canada outlined how omicron could be inflationary by disrupting supply chains and keeping demand for goods high as in-person service spending retrenches. I’ve also outlined how lockdowns in China could throw gasoline on the bonfire of supply chain bottlenecks.

So while omicron is increasingly likely to slow growth, it could also boost inflation. That risks an even tougher set of problems from Powell and the FOMC to navigate.

All told, I believe the chorus on inflation will be too tough for the FOMC to ignore. Tapering more quickly gives them the option of hiking sooner if omicron fizzles or causes unforeseen problems. Even if the variant proves to be a severe negative, a taper isn’t going to derail the underlying recovery, merely delay it.

The caveat

I think the market can easily absorb a taper but there’s a risk that it comes with communication that suggests rate hikes are a done deal once it’s completed in March. That sort of aggressive posturing might have been appropriate if not for omicron but given the state of play, it would risk sending a cavalier and reactionary message to markets. It would almost be a panic signal.

If it were to unfold that way, the market wouldn’t be pleased. Expect stock markets to drop, the yield curve to flatten and the US dollar to soar.

Doves will be doves

I think the market is underestimating the chance that the Fed takes a more cautious approach. While the FOMC is no-doubt stung by some of the criticism, there’s still good reason to believe that inflation will prove to be transitory. The Fed has entire teams dedicated to the positions they’ve held for many months.

The omicron variant is also a serious risk and that won’t be lost on the FOMC. If there is a big surprise on Wednesday — I give it a 10% chance — it’s that the Federal Reserve will stick to its previous taper timeline.

That kind of surprise would unwind some of the recent US dollar strength, much stronger stocks, higher gold and a steepening in the yield curve.

For this meeting, the clearest way to trade it will be the US dollar against a commodity currency. A particularly interesting chart at the moment is USD/CAD, which is threatening to break a series of highs stretching up to 1.2950. A hawkish decision would ensure that it does.

USDCAD daily chart

USDCAD daily chart

Read More : FOMC preview: Taper timeline likely to be cut in half | Forexlive

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