Tightening tantrum the next challenge for Fed guidance

The July FOMC statement did not change any of the key statements regarding the likely timing of rate hikes, which is increasingly likely to be the next move for policy once the tapering of asset purchases ends.

The FOMC did change some of the wording around inflation, with the recent uptick cooling fears that it will remain persistently below target.  With labour market readings continuing to push towards more normal levels, the FOMC will be thinking about the path to normalising policy.

The pace of growth also improved in Q2, with the annualised rate of 4% better than the partial data were suggesting for the quarter. Business investment and construction in particular appeared better than the monthly data were suggesting.

Looking at 1H14, its difficult to get too excited about ~2% p.a. GDP growth. But it does seem likely that it will stay steady and perhaps get a little stronger given the positive reinforcement from better employment growth.

Even though the pace of growth has slowed from the decent rates seen in 2H13, the current rates of consumption and business investment look like a solid enough foundation to keep things ticking over.

All this should be enough to keep the FOMC on the current path of tapering asset purchases, which will finish around September or October.

Around this point, the FOMC will have to think more clearly about guidance on the timing of rate hikes following the end of asset purchases.

Governor Yellen has alluded to a "considerable period of time", which is currently used in the statement, to something like 6 months.  That seems to be around current market expectations for an April hike in the Fed funds rate.

The big question for bond markets will be whether this change in rhetoric from the Fed will elicit the same kind of response as when Governor Bernanke first suggested a wind down in asset purchases in 2013.  This caused a very sharp movement in yields and created significant disruption in capital flows and FX markets in emerging markets in particular.

The "taper tantrum", along with somewhat weaker data, ultimately saw the FOMC hold off until December for the actually policy change, although by the point markets weren't so hung up on this policy coming into play. In fact, since then longer term bond yields have fallen significantly.

It's hard to see markets reacting to the same degree as they did in 2013 given the overzealous repricing of bonds ultimately went too far.

But its also difficult to see long-term bonds holding onto the gains they have seen in the YTD.

While there will be a lot of focus on the timing of the first hike, there will be lot of other things to consider.  First is the speed at which rates are projected to rise, which the FOMC will be at pains to say that it won't be very quickly.  At the moment there isn't a clear consensus for 2016, which may perplex markets in the 3-6 months time.

And while the Fed funds rate may rise, the composition and size of the Fed's balance sheet is unlikely to change anytime soon. This presents an extra challenge in understanding the stance of monetary policy as opposed to just the level and movement in policy rates.

Either way, it seems that the relative calm current engulfing relatively expensive longer term bonds yields is likely to give way to greater uncertainty in Q4.