“Twas The Night Before Taper” – Deutsche’s Joe LaVorgna Sees A $10 Billion Taper Shadow Tomorrow

There seem to be two camps at Deutsche Bank these days: one, lead by the observant and somewhat contrarian Jim Reid, who recently asked the all important question about 2014 (“what if there is a recession?”), who accurately observed that something “structurally changed” since the great financial crisis (pretty clear what), and who even dared to suggest that the Fed will never taper, especially with the economy so late in the cycle already. And then there is Joe LaVorgna, best known for having a losing track record to Groundhog Phil. It appears that this morning Joey emerged from his lair deep inside 60 Wall, sniffed the cold air, and saw the shadow of a $10 billion taper, which is what he predicts the Fed will do tomorrow.

LaVorgna’s full winter weather forecast:

The FOMC statement will be released at 2PM EST along with updated real GDP, unemployment, inflation and fed funds forecasts. The Chairman’s press conference will commence shortly thereafter. We are looking for a $10 billion Treasuries only taper—we have been projecting this since the much stronger-than-expected October employment data (reported on November 8), which was subsequently matched by a similarly strong November employment report. Current quarter growth prospects continue to brighten with second half output poised to average over 3%. Moreover, the budget sequester was loosened, as we also had anticipated, so there is little reason for the Fed to delay tapering, in our view. The fact that the 10-year Treasury yield is at nearly the same level as it was right before the September FOMC, while the timing of the initial rate hike was pushed out at least six months from early 2015 to late 2015, tells us that the financial markets are indeed expecting a taper. There is now much less concern on behalf of monetary policymakers that a taper will engender a further tightening in financial market conditions. Indeed, since the September non-taper, equity prices are higher and credit spreads are tighter.

Nonetheless, the Fed will look to blunt any negative reaction to a taper, which will help appease the doves on the FOMC by strengthening the Committee’s forward guidance; tapering is not the same thing as a tightening. The Fed wants to hammer home the message that even after asset purchases are completed, monetary policy will remain extraordinarily accommodative. Fed Nominee Yellen believes this will lower term premium and help anchor longerterm rates. How will the Fed strengthen forward guidance? Words are cheap (at least relative to other measures, such as tinkering with IOER), so we believe the best way to extend guidance is to change the threshold on the unemployment rate—especially since the rate is already at the level Chairman Bernanke had previously targeted for the completion of asset purchases. Note to Fed: If unemployment insurance benefits are not renewed next month, the unemployment rate could promptly fall another three-tenths. Conceivably, the unemployment rate could be 6.5% by the March meeting. Does the Fed really want to continue to have to explain why a 6.5% threshold is not a trigger for tightening and why investors should ignore it? It seems to us that the easiest and most efficient way to strengthen forward guidance is to lower the unemployment rate threshold to 6.0% (or possibly even 5.5%). What about the fact that just “a couple of participants” supported a change in the threshold? The minutes were compiled before William English—the Secretary of the FOMC and the most senior economist at the Board of Governors—presented a paper at the annual IMF meeting in November which said that the optimal unemployment rate for the Fed was 6% or lower.

We do not believe the Fed is going to cut the interest paid on excess reserves for two reasons: One, this will not stimulate lending; and, two, it could cripple the short end, potentially causing major negative consequences. For example, some large money center banks warned they would begin charging depositors. What about the forecasts? The Fed will likely slightly raise its long-term GDP forecasts, trim its near-term unemployment rate forecasts and essentially maintain its inflation forecasts. We doubt the fed funds forecasts will change appreciably, since the economic forecasts should be little changed.