To Taper or Not To Taper – This is the Question

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on Jan 26, 2021

Updated: Dec 19, 2022

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The main event of the week, and perhaps of the entire month, is the Fed’s meeting to take place tomorrow. The statement, followed by the press conference, will be closely scrutinized by market participants involved in all areas – stocks, commodities, currencies, fixed-income.

While everyone appears to agree on the fact that the Fed will not do anything tomorrow in terms of altering its policy, the big unknown is what will the Fed’s forward guidance be. I mean, the Fed already expects stronger growth in 2021 than initially thought, but will it be enough to warrant a change in the QE purchasing?

When a central bank buys bonds issued by its own government, the process is deemed as quantitative easing or QE. As a consequence, the central bank’s balance sheet increases with the new purchases. When the central bank reverses the process, it is called tapering. By reversing, I do not mean effectively selling the bonds. Only the idea of the Fed slowing the purchasing rate is enough to trigger a massive “taper tantrum”. After all, it happened in the past – will it happen this week too?

QE Tapering – A 2021 or 2022 Story?

The Fed is still likely to start tapering only in 2022 than 2021. However, in the meantime, some new factors are worth considering when trying to solve this puzzle.

One is the new administration in Washington. While the Trump’s administration publicly favored a weak dollar and cheered for the stock market, the new administration is unlikely to express its stance publicly.

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The new Treasury Secretary, Janet Yellen, was the Fed’s Chair for a few years. She is known for starting the previous tapering, stating that the process of shrinking the balance sheet should be as boring as “watching an oil paint dry”. Needless to say, the market did the opposite, and the Fed was forced to bring the tapering to a halt sooner than initially planned.

Another is the gap between the Treasury’s new issuance and how much the Fed can and is willing to buy. Remember that a central bank acts as the bank for the government, so if the government wants a huge fiscal stimulus but does not have the money, it turns to the Treasury and the central bank. The Treasury issues debt, but if the Fed does not buy the entire issuance, we effectively have a tightening of financial conditions.

All in all, currency traders should mark their calendars and be prepared for wild price action on Wednesday. The USD’s volatility should be on the rise.

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