With talk of "tail risks" – like a hard landing in China, the U.S. going over the "fiscal cliff," or a country exiting the euro – fading from the collective discussion, arguably the biggest open question for markets right now is when the Federal Reserve will begin to tighten monetary policy.
Deutsche Bank economist Joe LaVorgna thinks the central bank could be ready to start slowing its quantitative easing program as early as June.
In a note to clients today, LaVorgna writes:
The Fed unexpectedly began discussing when to diminish and terminate QE at last December’s FOMC meeting. These deliberations no doubt continued at the January meeting for which we get the minutes today. We do not expect the minutes to suggest the Fed is quite ready to slow the pace of its $85 billion per month of open-ended Treasury and mortgage purchases. After all, policymakers did not have the February employment report when they met in late January, which showed decent job growth—nonfarm payrolls were up +157k—and sizeable upward revisions—the level of December 2012 employment is now about 650k higher than what was first reported.
Simply put, not enough changed in the economic outlook between December and January to constitute a material change in the Fed’s economic and financial assessment. However, based on our GDP, unemployment and inflation forecasts, we believe policymakers will eventually announce their intention to slow the pace of QE by June and to halt QE altogether by the end of December. Note there are three more FOMC meetings between now and the end of June—March 19-20 (press conference), April 30-May 1 and June 18-19 (press conference). We expect interest rates to rise when the Fed dials back its purchases and then to rise further in the second half of this year in anticipation of QE being completed.
Concerns over ending QE were brought to the fore in early January, when the Fed released minutes from the December FOMC meeting.
The minutes revealed a surprisingly hawkish sentiment inside the Fed with regard to QE:
In considering the outlook for the labor market and the broader economy, a few members expressed the view that ongoing asset purchases would likely be warranted until about the end of 2013, while a few others emphasized the need for considerable policy accommodation but did not state a specific time frame or total for purchases.
Several others thought that it would probably be appropriate to slow or to stop purchases well before the end of 2013, citing concerns about financial stability or the size of the balance sheet. One member viewed any additional purchases as unwarranted.
Analysts like Société Générale's Sebastien Galy think this will be the big story of the second half of 2013.
Galy wrote in a recent note to clients that once the market is able to anticipate a Fed tightening, which he thinks will happen "most probably" in the second half of this year, "we will see a rising U.S. Treasury 10-year yield drive all before it, leading to a brutal reallocation of risk."
However, if LaVorgna is right, things could get interesting a lot sooner.
At any rate, we may get more clues from the release of the minutes from the January FOMC meeting, due out Wednesday at 2 PM ET.
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