Why the Time to Taper Is Still Right Now

DailyFX

Friday’s non-farm payrolls (NFP) report cast much doubt over the likelihood for Fed tapering, but given the market’s expectations and favorable bond market conditions, the best time to taper may be right now.

In December 2012, the Federal Reserve tied interest rate hikes to the unemployment rate, making it clear that job creation is the number-one focus. For this reason, Friday's non-farm payrolls (NFP) report was extremely important, and now, the central bank has a tough decision to make in less than two weeks.

Whether it is a mistake or not, policymakers have been extremely vocal about their intentions to reduce asset purchases, and through their comments, they have effectively committed to a major policy change before the end of this year.

Up until Friday's NFP release, the lack of consistent improvements in US economic data had investors divided on when the central bank will act, and the highly disappointing payrolls report doesn't make the decision any easier.

Payroll growth was weak, and despite the decline in the unemployment rate, the labor participation rate hit a 35-year low, but a number of Fed Presidents, including Federal Open Market Committee (FOMC) voter Esther George, who spoke after the jobs number, still believe that the central bank should taper this month.

In fact, George called for asset purchases to be cut by $15 billion in September, with future purchases split evenly between Treasuries and mortgage-backed securities. Granted, however, George has voted against continued quantitative easing (QE) for the past five meetings, and her views may not be a huge departure from those of her colleagues.

Based purely on the decline in the unemployment rate, the Federal Reserve should begin to taper. Back in June, Fed Chairman Ben Bernanke indicated that the central bank would begin to reduce the size of its asset purchases later this year and end them completely next year. He added that, "In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7%."

The jobless rate is now at 7.3%, which is not far from the target level, but the problem is that people dropping out of the workforce is to blame for the decline, not stronger labor market conditions overall. Now, the Fed has a difficult decision to make, and while the chance of a reduction in asset purchases in two weeks’ time has declined, it is not off the table altogether.

For this reason, Friday’s NFP report has definitely hurt the US dollar (USD) rally, but has not killed it completely. Further position adjustments are likely, though.

We know there is a high level of support inside the central bank for reducing asset purchases, and the only question remains the timing. Given the recovery in bond prices and fall in US Treasury yields, there may not be a better time than right now for the Fed to taper.

If the central bank stays on course, any changes in monetary policy will be symbolic, which means policymakers could opt for an incremental reduction wrapped by a dovish FOMC statement intended to prevent a rebound in yields.

Between the slowdown in the labor market recovery, debt ceiling debate, and geopolitical tensions, the Fed could also delay changes until December, but the proximity of the holidays and the end of Bernanke's term makes this option less palatable.

Retail sales data will be released this week, but that is the only noteworthy US economic data on the calendar. Considering that the report is not due until Friday, investors will most likely spend the week digesting the payrolls data and Chinese economic reports. A number of key releases are expected, including trade balance, which could drive risk appetite in an otherwise quiet week.

By Kathy Lien of BK Asset Management

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