Most people expect the Federal Open Market Committee (FOMC) to announce the beginning of tapering after its September 18 meeting, but the pace of structure of tapering is still up in the air. With falling unemployment and strong Fed credibility, Societe Generale analysts Mary-Beth Fisher and Aneta Markowska expect tapering to proceed faster and end sooner than consensus estimates.

Fed to announce tapering

“Broad consensus in the market is that the Fed will announce the tapering of its large scale asset purchases (LSAPs) at the 18 September meeting,” write Fisher and Markowska.  “Estimates for the Fed’s initial reduction of its $85 billion per month in asset purchases range from a $10 billion per month cut to $20 billion per meeting cut.”

Societe General’s initial estimate is at the low end, a $10 billion per month reduction, but the Fed has indicated that the speed of tapering will be tied to an unemployment level of around 7 percent, and the country is already at about 7.4. The non-farm payroll (NFP) report due in early October will give a better idea, but the consensus might be underestimating the drop in QE from there.

“The market is currently assuming that asset purchases run through June 2014,” write Fisher and Markowska. “We believe that the unemployment rate is on track to reach 7% by Q1, i.e. ahead of the Fed’s expectations. In that scenario, the Fed will be under significant pressure to end asset purchases earlier than planned.”

SG Tapering expectations

Fed’s bond buying program

Separate from the pace of tapering is how it’s broken down. Right now the Fed is buying $45 billion per month of Treasuries and $40 billion per month of mortgage backed securities (MBS), and financial institutions heavily involved in the mortgage market are arguing that the Fed should taper UST first and MBS afterward. “There has certainly been no indication to date that the FOMC intends to treat the two asset classes differently. We expect the Fed will choose to taper purchases of both Treasuries and agency MBS on a roughly equal basis and end them at the same time.”

If tapering does treat both asset classes equally the mortgage basis should pull back about 10 bp, as preferential treatment seems to currently be priced in.