Also adding fuel to the "tapering" discussion was Tuesday's report from the Congressional Budget Office showing that the federal deficit had narrowed more than expected. The deficit has been more than $1 trillion a year for the past four years but is now running at $642 billion for the fiscal year ending Sept. 30, according to the CBO. That would be just four percent of the nation's annual output, and the CBO said it could shrink to 2.1 percent of GDP by 2015.
Three months ago, the CBO forecast that the deficit would be $845 billion, or about 5.3 percent of economic output, but higher taxes and spending cuts have reduced it more quickly. In recognition of that, the Treasury said in its last quarterly refunding announcement that it could reduce issuance in coming months.
That put the focus on the Fed, which is buying $40 billion in Treasury securities every month.
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"A big part of the improvement you see in 2013 is $200 billion of that is basically once-off stuff, but we have expected and continue to expect in the next five years the trend in the deficit to improve," said Michael Feroli, JPMorgan's chief U.S. economist. "You're going to get cyclical improvement," he said, adding that longer-term issues have not been addressed.
Feroli said he expects the Fed to begin tapering in December. However, it could begin to communicate more about it as early as its June meeting and is likely to refer to it in the minutes of its last meeting, which will be released next Wednesday.
Markets had been taking the recent talk of tapering in stride, but comments from San Francisco Fed President John Williams late Thursday sent stocks slightly lower, boosted the dollar and sent bond yields slightly higher. Williams, a non voter, said the Fed should begin tapering in the summer, if the job market is strong enough, a position that is more aggressive than traders expect.
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Earlier Thursday, Philadelphia Fed President Charles Plosser, who does not vote on policy this year, reiterated his view that the Fed should start to taper next month.
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JPMorgan economists wrote in a note Wednesday that they do not expect tapering to result in tightening of financial conditions. They also said that concerns that it could trigger the kind of tightening that occurred when the Fed raised rates in 1994 are unwarranted, as conditions are far different and the Fed has been communicating openly.
Feroli said he imagines the Fed might take two swipes at reducing its purchases before stopping them altogether. Rates will be higher once purchases are pared back.
"This is going to happen if data continues to come in well, and jobs numbers come in good, and the bond market will react, and I think it will probably be there by the time the Fed starts to taper. Rates will be higher than where are ," he said. As for stocks, "they're going to be tapering because the economy is going to do presumably better. I think stocks can handle it if the economy is doing better."
Another reason the market is talking tapering: An article in The Wall Street Journal last weekend said the Fed was planning its exit strategy. It quoted Fed officials as saying they plan to reduce the amount of bonds they are buying in "careful and potentially halting steps," varying purchases as their confidence about the "job market and inflation evolves."
The article also said timing was still being discussed. The story followed rumors several days earlier that a Journal article on tapering was in the offing—talk that jolted stocks.
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Art Cashin, UBS director of floor operations, said the Fed—not just the Journal—needs to talk about tapering.
"What I'm looking for at some point, the Fed is going to have to talk about it, not just the tapering—the fact that there are fewer mortgage bonds, fewer Treasury bonds." The Fed must respond to the fact that it still plans to buy $85 billion securities a month in what looks to be a smaller pool, he said.
Tapering is just a first step, and unwinding programs is expected to take years, particularly since the Fed may hold many of the securities on its balance sheet.
David Ader, CRT Capital chief Treasury strategist, said it's far from definite that the Fed is going to reduce purchases this year but that tapering will have an impact when it happens.
"It's a dark area. … We're right in the middle and on the margin of which way this thing can swing," he said. "I don't think we are talking about it with more intent today.
"Tapering is just easing the pace of the accommodation in the system, as opposed to tightening and trying to slow things down," Ader said. "They are still trying to keep things easy, and that in itself is important."
The 10-year yield, at 1.94 percent Wednesday, will likely move in a range of between 1.70 and 1.75 perceny and 2.0 and 2.05 percent for the next few weeks, Ader said.
"Tapering of QE is going to impact the long end, and in that respect, the Fed is going to be much more sensitive to its influence on mortgages," he said.