Fed Fiesta

So if Bernanke sticks with September to taper off QE and bending to the wishes of the inflation hawks then Zero Hege / Canandian investor were right in their reading of the tea leaves. They suggested there was a quid pro quo where Bernanke obtained consensus for more QE in the face of the fiscal cliff in exchange for tapering later if things weren't a disaster. Plausible but I'd bet against Zero Hege.

Fed Watch: FOMC Meeting Begins Tomorrow by Tim Duy

What the bond market is telling the Fed by Gavyn Davies

The “lower for longer” message on rates, which has been so carefully crafted by the FOMC’s forward guidance, seems to have been thrown overboard by the bond market with remarkable alacrity as soon as the Fed has indicated that it may slow the pace of policy easing. The reason for this is that past history is replete with episodes in which the Fed has tightened policy very rapidly once its enthusiasm for easing has started to wane.

The 1994 example, when the Fed failed to guide the markets about the likely pace of tightening, is of course part of the folklore of the bond market. Less well remembered is the example of 2003, when the first signal that the Fed was slowing the pace of easing was followed by a 100 basis point rise in bond yields within a few months, even though the Fed’s forward guidance about tightening at a moderate pace was increasingly explicit.

The problem is that, once the market starts to believe that the Fed is “done”, it will inevitably start to build into the yield curve a rising probability that the FOMC will embark on a normal path of tightening before too long. In order to mitigate this, Mr Bernanke is likely this week to remind the markets that the intention to slow asset purchases “in the next few meetings” is contingent on events in the labour market, is not the start of policy tightening, and is completely distinct from any intention to start raising rates.

The Fed has of course said that it will keep short rates at near zero until the unemployment rate has fallen to 6.5 per cent, subject to projected inflation remaining under 2.5 per cent. One way of forcing home the message that this will not happen soon would be to reduce the unemployment threshold to 6.0 per cent. This would be in line with the Fed’s fundamental view of labour market behaviour, as previously argued here.

If the chairman wishes to regain control of the market’s path for forward short rates, he may need to reduce the unemployment threshold to 6 per cent before too long. But I do not expect him to go that far this week.

It's not just the Fed by James Hamilton

When it does announce tapering, the Fed will try to reiterate that the rise in short-term rates will still not come until much later. But just as QE3 added emphasis to the declaration of a commitment to an extended period of low interest rates on the way down, ending QE3 will tend to detract from that message as we start to look at the path back up.

And just as a weak economy was the primary reason the Fed embarked on QE3, a strengthening economy will be the primary reason the Fed ends it. And if the economy is strengthening, interest rates will be headed up, regardless of whether the Fed keeps buying bonds or not. It's worth emphasizing that the recent rise in interest rates has been a global phenomenon, not just something seen in the United States.

Interest rates on 10-year government bonds, weekly, June 1, 2012 to June 13, 2013 for the US, Canada, and the UK.

If you want to claim that the recent rise in rates is just an anticipation of what the Fed is going to do, the story has to be that the U.S. Federal Reserve is causing the whole world to move.

The alternative view is that it's a big world out there that will ultimately force the Federal Reserve to move.