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The Fed's First "Policy Error" Was Not Yellen's "Dovish Hold" But Bernanke's Tapering Of QE3

Two days before the Fed confused everyone when it delivered neither a dovish hike nor a hawkish hold, but the most dovish possible outcome, we warned readers that the September FOMC announcement could be a carbon copy replica of what happened precisely two years ago, when everyone was expecting Bernanke to announce the Fed's taper - a sign the US economy was solidly improving and QE was a success and thus can start being unwound - only to get precisely the opposite when Bernanke said "no taper", leading some to wonder if this had been the Fed's first major policy, and communication, mistake.

Sept. 18, 2013: Fed shocks market when it "unexpectedly" refrains from QE taper

— zerohedge (@zerohedge)

Fast forward to Thursday's Fed statement and subsequent market reaction which prompted many to ask if Yellen's own error did not just cost the Fed a substantial dose of credibility, because this may well have been the first time when a dovish Fed led to such a major market selloff.

And while there was no selloff in September 2013 when the Fed refrained from tapering, the market reaction in December 2013 when Bernanke did announce the tapering of QE3 was very clear: an initial drop followed by a massive surge.

Ironically, according to Deutsche Bank, it was not the Fed's Thursday announcement that was the Fed's most notable mistake, but Bernanke's 2013 Taper announcement, which the market perceived as an all clear signal for the economy, only to realize just how clueless the Fed truly has been all along.

Here is DB's Dominic Konstam explaining why for the Fed, the mistakes are starting to pile up, with the December 2013 tapering start being the first and foremost one.

At a recent investor gathering a question was asked, prior to the FOMC meeting, in the spirit of why the Fed should raise rates, whether or not anyone could argue that tapering itself was a “mistake”. It is an interesting question but the answer is surely a resounding “yes”. While a counterfactual is hard to prove, the impact of tapering in rates space is self evident. From the moment it began we saw a relentless fall in long term rates and a return to where those rates more or less stood around the onset of (endless) QE3. The cost of tapering should therefore be viewed in terms of what we have lost in rate space. If we think of 5y5y OIS as a terminal Funds rates, we have lost the best part of 200 bps in terminal funds and still counting. The Fed has managed to recognize about 75 bps of this so far in terms of dropping their terminal funds rate projections.



One conclusion from the taper mistake is that if the Fed wants a sustainable normalization of rates it needs to be considerably behind the curve. It can never raise rates if the market discounts lower rates. Our confident prediction  is that the Fed will raise rates only when the market is begging for it and it should do it more slowly than the market discounts. That means the curve needs to be a lot steeper and the terminal rate priced a lot higher than currently. For the Fed to move otherwise, normalization is bound to fail i.e. be short-lived and partial. Recognizing this the Fed would do well to signal that by explicitly relinquishing any claim to higher rates through 2016. There might then be a chance that they could actually hike in 2016.

Just in case anyone is still harboring any hope that the Fed may hike in October or December, or even any time in early 2016, allow us to disabuse you of such a fallacy, thanks to the recent devaluation chaos out of China. DB continues:

For Yellen the uncertainty is that if the yuan is to fall further, it may not be now but perhaps year end or even later. There would need to be a clear shift positively in China’s fundamentals for that uncertainty to dissipate. Meanwhile any adjustment if and when it came would add to disinflation concerns at home and, presumably, at least initially adversely affect stocks, led by other Asian equities.

Confused by what all of the above means? Simple: forget any rate hike now or for the foreseeable future. The Fed just got its first major wake up call by the market that it made a policy error, a mistake which it can and will trace to the QE4 unwind. Which means one thing: if Yellen decides to undo the Fed's mistake, having not hiked on Thursday, she will next undo Bernanke's last error: the naive hope that the US can operate without a regime of epic liquidity, i.e., either printing money once more in the form of QE4, 5, etc... or, as Kocherlakota hinted, the arrival of NIRP.

One thing is certain: with the market tumbling, and with Bank of America admitting yesterday that a plunge in the S&P below 1870 to hint that QE4 is on the table, there is much more debasement of paper currencies on the horizon as the Fed grudgingly admits it is back to square one.