Saturday, December 21, 2013

Can We Taper?

Can we taper?
Written: December 18, 2013

As an options trader all I want to see tomorrow is a message that will give me a rally in the major indices so that I can benefit from an increase in implied volatility to the upside.

That being said, I don’t believe the Fed will initiate a taper in its asset purchases tomorrow. Over the past 12 months, non-taper decisions and guidance have lead to market rallies as investors love liquidity in the markets, regardless the source. However, this time is different. This time I believe the rhetoric of the Fed statement, and NOT so much the decision (taper) in and of itself will influence the reaction of the markets.

Over the past fiscal year, the FOMC has re-iterated that improvements were clearly present in the US economy, yet when looking at the state of the economy from an overall perspective, sluggish data still existed. The FOMC will not feel comfortable tapering until it gets multiple months of steadfast and consistent data to underpin its decision. Although we have seen promising signs over the past 3-4 months, I am not convinced that we are in the clear, and at this point I don’t think the Fed is willing to risk a lackluster transition away from QE or induce unhealthy volatility in the financial markets. Further, this will be the last meeting that current Chairman Dr. Bernanke conducts and will he really be ready to start a taper that he cannot finish? I don’t think so; I think it would be wiser to leave the beginning and end of the taper for the next FOMC regime.

Lets clarify in short, a bit of what the fed has been reviewing today and will review tomorrow leading up to the statement. The data includes:
 Unemployment %
 Non-farm payrolls
 Initial claims
 University of Michigan’s Consumer sentiment read (CSI)

Other valuable data will also be considered such as CPI & PPI measures, housing starts, PMI values along with consumer and producer spending indices, however the aforementioned data measures are what I will briefly touch on.

1)    GDP has grown through out the year, but at a less than optimal rate of 2%. Although this growth is consistent, would it remain this way with out QE? If GDP had grown at a level of say 4%, a reduction in its future growth without QE would be acceptable at 2% in my eyes. Yet I don’t think the US economy can be very resilient off less than 2% GDP growth.
2)    The Unemployment rate was down to 7% as per this months reading. This number is down from the previous months reading of 7.3%. The fed has stated a target revolving around 6.5% and we clearly are still not there. Yes we are improving, but I would think the committee would want to reach its target and sustain that value for multiple periods before it reduced its asset purchases.
3)    Non-farm pay rolls have indeed been promising. This month’s gauge read 203k. An increase from last months reading of 200k and significantly outpacing consensus forecasts that looked for a reading around 185-188k. I don’t mean to sound overly negative, because in reality I am an optimist, yet what many have not accounted for in this reading is the labor market fluctuations that come with the holiday season. Holiday seasonal workers add a considerable amount of weight to this measure along with other employment and labor market condition measures. Without a clear view of net employment numbers, accounting for seasonal fluctuations; I don’t believe the Fed can come to a conclusion regarding the employment and unemployment picture.
4)    Initial claims last week rose to 368K from a 300k-revised measure in the previous week. This uptick in claims may have a correlation with some seasonal jobs coming to a close, however as this month’s non farm payroll numbers were reported before this weeks initial claims metric, next months payrolls will give us a better insight into a possible correlation here.
5)    The Michigan CSI metric increased to 82.5 this month from a previous read of 75.1. Increased consumer sentiment measures are always good for the economy, as they imply that average consumers and citizens feel better about the current state of the economy, and will thus participate in retail or other markets more actively. However to be clear, this measure is only a move back to CSI levels prior to the government shutdown. This is another measure that I believe still needs to hold still and/or increase over the next couple of months to prove consistent.

My opinion is that we are indeed making progress towards a smoother functioning economy,that can positively evolve without government assistance. However to use a baseball metaphor, rather than us being in the bottom of the 9th inning of this process, we are in the top of the 6th. We’ve rounded the corner with reference to the economic secular changes and/ or market corrections incurred following the housing market crisis, yet the economic and financial markets data need to prove they are able to sustain strong results for a significant time period.

If we can sustain meaningful results in the above discussed and other determinant economic measurements, then I think the taper will be initiated. My perception is that this time will be soon and in the first half of 2014. I believe the fed will wait for one chairman to start and end the process of a reduction in asset purchases, as well as patiently wait for new economic data to confirm their decision.

*This is my view of what will happen today, I would not be overly surprised however, if Dr. Bernanke was to initiate tapering as his final FOMC decision.

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