The US Federal Reserve could justify tapering its US$85 billion quantitative easing (QE) program at any of its next three meetings based on the recent economic data, but January or March 2014 are more likely than December 2013, according to the November Bond Market Observations from Standish.
While positive reports on the US economy could lead the Fed to reduce asset purchases sooner, the unresolved fiscal situation will more likely delay tapering until next year, Standish said.
When the Fed finally does taper, modifications to its forward guidance could help soften the impact on Treasury yields and global financial markets, the report said.
Enhanced forward guidance should increase the predictability of Fed policy and hold down interest rate volatility which in turn would be likely to benefit investment grade credit, high yield bonds and loans, and emerging market debt.
The Fed is contemplating several changes to its forward guidance including establishing an inflation floor and lowering the unemployment threshold. Standish believes the Fed is unlikely to take the latter action given the damage it might cause to Fed credibility.
Successfully conveying forward guidance could lead to continued low interest rate volatility and a gradual rise in Treasury yields as economic fundamentals improve.
Thomas Higgins, chief economist and global macro strategist for Standish and author of the report, said: "The transition to higher rates could be rougher if investors confuse tapering with tightening. There’s a danger investors could price in interest rate hikes sooner than the Fed intends once tapering begins."
However, the report adds the risk of another violent sell-off in the market, similar to the one in the spring and summer of 2013, is less likely given that long-term interest rates have already increased sharply. Furthermore, the Fed has said the federal funds rate is unlikely to rise before mid-2015.