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By HaleStewart December 21, 2013 8:37 am
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International Week In Review: Let the Tapering Begin

The biggest news last week was the Federal Reserve's announcement that they would start the tapering process.  Here is the exact wording from their press release:

Beginning in January, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $35 billion per month rather than $40 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $40 billion per month rather than $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.

Note the Fed will still reinvest the principal as it comes due.  That tells us the Fed isn't getting out of the stimulus game just yet. 

The emerging concensus is the Fed will continue to taper $10 billion/month at each of its next meetings, eventually reaching 0.   This, of course, assumes there is no major slowdown in US economic news. 

Adding credence to the Fed's move was the announcement that US GDP increased 4.1% in the Q1.  Growth was very broad-based, as detailed in the report:

The increase in real GDP in the third quarter primarily reflected positive contributions from private inventory investment, PCE, nonresidential fixed investment, exports, residential fixed investment, and state and local government spending that were partly offset by a negative contribution from federal government spending.  Imports, which are a subtraction in the calculation of GDP, increased.

Despite these events, the dollar index's performance is still remarkably subdued as shown in this yearly chart:

The initial tapering announcement was on May 1 when the dollar index was at 81.5.  The index rallied twice immediately following this announcement, but since early July the index has been moving lower.  From peak to trough (~84.5 - ~79), the index has dropped 6.5%.  Since hitting yearly lows at the end of November the index has bounced back, but hardly in a strong rally.  And while higher rates (from the treasury market sell-off) will help the dollar, they will also slow the economy especially the nascent housing rebound.

The news out of the UK continues to impress.  GDP increased .8% Q/Q and 1.9% YOY.  Also of importance -- a note in the latest GDP report stated that UK GDP has been continually revised higher since 1Q12 as a result of increased household spending.  Retail sales were up 2% YOY and .3% M/M.  The unemployment rate dropped .2%, moving from 7.6% to 7.4% and inflation remains fairly subdued, with the YOY core reading at 1.8% and total M/M at 2.1%.

India maintained rates at 7.75%, taking a wait and see stance as they hoped that recent rate hikes (which have a delayed effect) will start to slow inflation in the coming months.  However, the report's overall assessment of the current situation was not encouraging:

In India, the pick-up in real GDP growth in Q2 of 2013-14, albeit modest, was driven largely by robust growth of agricultural activity, supported by an improvement in net exports. However, the weakness in industrial activity persisting into Q3, still lacklustre lead indicators of services and subdued domestic consumption demand suggest continuing headwinds to growth. Tightening government spending in Q4 to meet budget projections will add to these headwinds. In this context, the revival of stalled investment, especially in the projects cleared by the Cabinet Committee on Investment, will be critical.

Retail inflation measured by the consumer price index (CPI) has risen unrelentingly through the year so far, pushed up by the unseasonal upturn in vegetable prices, double-digit housing inflation and elevated levels of inflation in the non-food and non-fuel categories. While vegetable prices seem to be adjusting downwards sharply in certain areas, the feed-through to much-too-high headline CPI inflation remains to be seen. Wholesale inflation has also gone up sharply from Q2 onwards, with upside pressures evident across all constituent components. High inflation at both wholesale and retail levels risks entrenching inflation expectations at unacceptably elevated levels, posing a threat to growth and financial stability. There are also signs of a resumption of high rural wage growth, suggesting second round effects that cannot be ignored. High and persistent inflation also increases the risks of exchange rate instability.

Finally we have the EU, where the news again sent mixed signals.  On the negative side, CPI was .9% YOY and 0% M/M.  This gives traders reason to maintain their concern about a potential deflationary period in the region.  However, the Markit Composite press release had some encouraging news:

Manufacturing led the upturn, with output rising for the sixth successive month and the rate of increase hitting the highest since April 2011. New orders at goods producers likewise rose for a sixth month, also showing the fastest expansion since April 2011. Order book growth was fueled by rising exports, growth of which continued to run at the fastest clip since early-2011.

Key to the report were the "best numbers since 1H11" points.  Manufacturing new orders are key leading indicators, and industrial production is perhaps one of the most important coincident indicators.

So -- the Fed finally announced its tapering plans.  However, the market has been expecting this news for the last nine months, making the announcement a bit ant-climactic.  UK news continues to impress, adding further fuel to the pound's fire.  India is still a mess and will be for some time and the EU is still sending concerning signals.

Hale Stewart is a former bond broker who has been writing about economics and financial markets since 2006 on the Bonddad Blog.  He is also a tax attorney with a domestic and international practice while also forming and managing captive insurance companies for US companies.   You can follow him on twitter at:@captivelawyer

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