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The Fed is on the horns of a dilemma. Federal Open Market Committee (FOMC) members are uncomfortable with continuing what they viewed as an emergency-style program now that the jobless rate is at less dramatic height. As long as we see even moderate growth and minor progress on the jobless rate, they are determined to bring Quantitative Easing (QE) to an end. But they face the delicate task of doing so without prompting a spike in long-term rates that would undermine a still-fragile recovery that rests to a significant degree on housing, a sector sensitive to long rates.
Note how 10-year rates have moved up as media attention on tapering escalated, even as news showed that first-half U.S. economic growth averaged less than 1½ per cent. That belies the results of a San Francisco Fed simulation that came up with a much smaller impact of QE on the yield curve, one that rested on what we view as an overly restrictive model for investor behaviour. Other studies, looking at the actual history of how the market shifted around QE announcements, or equivalent events that changed Treasuries supply to the market, have found much larger impacts on the rates, over and above those tied to guidance on short rates. Moreover, the sharp sell-off we’ve seen in yields on the mere mention of “tapering” by Fed doves belies the notion that guidance alone can be as effective in easing rates across the full curve.
Here are three tools the Fed is likely to employ, judging by its past tactics, to minimize the bond market hit, a reason why we argue that the next leg for higher long rates will be a 2014 story, even if tapering begins this year.
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