ANALYST: The Fed Has Three Options For Tapering QE In January

Most of the Wall Street commentary on "tapering" of the Federal Reserve's quantitative easing program has been a discussion of when it's most likely to happen.

Following the release of the November jobs report last Friday, strategists at TD Securities are now pretty convinced that the first tapering announcement will come from the January FOMC meeting.

"The question going forward is how well the curve is positioned for QE tapering at the January 28-29 FOMC meeting, and we believe the answer relies on the magnitude of the taper," says TD strategist Gennadiy Goldberg.

In a note to clients, Goldberg examines three options the Fed has for announcing tapering at the January meeting:

TD Baseline: $15B Taper (Split $10B UST, $5B MBS)

With economic data since the October government shutdown continuing to show measurable strengthening, we believe the market has gradually adjusted for the possibility of a January taper. In fact, the long end of the curve's reluctance to sell off further following Friday's strong payroll report is a case in point. The 3% level on 10s and 4% level on 30s should prove strong resistances in the near-term, suggesting that while the long end of the curve is properly positioned for tapering as yields remain near September highs, the belly of the curve may need to adjust further.

The belly was substantially cheaper heading into an expected tapering announcement in September, with the 2s5s10s fly trading at 0bp ahead of the September FOMC. While the Fed's intention to signal increased forward guidance may have had a hand in keeping 5yr yields relatively contained (2s5s10s fly is currently at -17bp), we believe there may be more adjustment to come in the belly. We expect long-end yields to languish near September highs in the event of a January tapering announcement, with belly underperformance helping to flatten the 5s30s curve toward 230bp.

Alternate Scenario #1: $10B Taper ($5B UST, $5B MBS)

A $10B tapering would represent the Fed under-delivering relative to market expectations, potentially signaling a slower pace of QE wind down as it undertakes a more cautious approach to exiting QE. The curve would likely bull flatten in this scenario as 5s richen further on the curve as the long-end readjusts for a slower wind down of QE purchases (pricing in a higher absolute level of purchases before the program ends). This scenario could drive 5s back toward the post-September yield lows of 1.25% as 30s rally toward October lows of 3.60%, leaving the 5s30s curve trading closer to 225bp.

Alternate Scenario #2: $20B Taper ($10B UST, $10B MBS)

The Fed's recent rhetoric suggests that the QE unwind could occur relatively quickly as the Fed is anxious to get away from QE and return to a forward guidance-based approach. Nevertheless, Fed's Bullard and Lacker suggested on Monday that the Fed should undertake a cautious approach to tapering. We therefore expect the market to see a $20B tapering as relatively aggressive, likely leading to further selling on the long-end of the curve as the market attempts a break through 3% on 10s and 4% on 30s. It is worth noting that the curve steepening under this scenario could be more substantial if the more aggressive cut is accompanied by extended forward guidance, helping contain some of the selloff in the curve belly. We expect 5s to cheapen modestly in this eventuality as the 5s30s curve steepens back to a fresh post-Twist high of 260bp.

Expect to see more like this in the coming days and weeks, especially if, as is mostly expected, the Fed refrains from announcing a tapering at the December FOMC meeting next week.