Pieces falling into place for QE tapering

On balance, it looks like there is enough in the data for the FOMC to cut back QE.  The decision of now vs. the next meeting really comes down to whether they want to provide more communication or not.  Given markets are much more stable than they were in during the communication breakdown in September, they will probably be comfortable with tapering at the December meeting.

The strong payrolls data released today confirms that employment growth has genuinely improved, with the last 4 months now averaging over 200k in gains.

The unemployment rate dropped to 7%, although the participation rate is still quite a bit lower than the start of the year.  I think the assessment of the FOMC will still be that there is plenty of slack in the labour force and the economy in general despite the unemployment rate being a lot lower.  But given the signs of improvement, it seems to be time to adjust policy nonetheless.

Its not just payrolls that has proven to be better. Key leading indicators in the ISM surveys have been strong.  Preliminary readings on consumer confidence have been good.  Housing related data suggests higher rates haven't created too much damage to the housing recovery so far while consumption has gotten better.

The one caveat is that inflation has continued to be uncomfortably low.  Inflation expectations as measured by 5 year TIPs aren't overly alarming at ~1.7%, but it is still lower than where policy makers would like it to be.

This won't be a problem if they expect inflation to rebound, which is part of their projections.  But they will want to be fairly confident that this is the case.

It is encouraging for the FOMC that many have brought forward their expectations of tapering of QE, but this has not pushed bond yields dramatically higher like it did heading into September.

Part of the reason seems to be that expectations on rate rises are much more anchored than they were back in September.

To be sure, the market got way ahead of itself in terms of pricing in rate hikes, but the Fed has made it clear that just because they are winding back QE, doesn't mean rate hikes are coming any time soon.

Finally, it seems that markets have already absorbed a large part of the risks associated with the very low term premiums seen mid-year, with nominal 10-year term premiums on US treasuries heavily in negative territory before recently (shown in the red line on the chart on the left).

While this is still below average levels of ~50bps, the sharp rise in yields since the start of the year could now be seen as unwinding this unusual situation.  So while talk of tapering may see the term premium rise a little further, its very unlikely to move another 100bps.