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Analysis: Syria, debt ceiling worry has markets questioning Fed taper

The facade of the U.S. Federal Reserve building is reflected on wet marble during the early morning hours in Washington, July 31, 2013. REUT
The facade of the U.S. Federal Reserve building is reflected on wet marble during the early morning hours in Washington, July 31, 2013. REUT

By Wanfeng Zhou

NEW YORK (Reuters) - Until a few days ago, it looked like a sure bet that the U.S. Federal Reserve would announce the beginning of the end of its massive bond buying program in September. Now, investors are less certain.

The prospect of Western military action against Syria has sent stock markets worldwide reeling. Emerging markets have sold off and oil prices soared to six-month highs. And another potential showdown over the federal debt ceiling limit is looming this fall.

Taken together, the developments have eroded the conviction of most Fed watchers that the U.S. central bank would start backing off its $85-billion-a-month bond buying program, known as quantitative easing, or QE, at its September 17-18 meeting.

"It's a really big decision to start tapering because it's really like an exit strategy from QE and that's very hard for the Fed to do as long as there is a lot of uncertainty in the market like we're seeing right now," said Douglas Borthwick, managing director at Chapdelaine Foreign Exchange in New York.

"I certainly think the market is moving toward a delay into December."

U.S. officials have described plans for multinational strikes on Syria that could last for days. Concerns over the security of oil supplies across the Middle East, which pumps a third of the world's oil, drove Brent crude oil to a six-month high of $117.34 a barrel.

French bank Societe Generale said Brent crude could spike to $150 if the conflict in Syria spreads and disrupts supply. Higher prices would increase gasoline costs and slow other spending, which could affect the Fed's thinking.

"I think the probability has fallen that they do something in September," said Stephen Jen, managing partner of SLJ Macro Partners, a hedge fund based in London. "There could be a war in a part of the world that would drive oil prices substantially higher. And they're not low now.

"Sure the Fed could still do it. But if oil rises another $20 a barrel from here, I don't know why they would feel they had to do it now," he said.

Some analysts said the impact from Syria on financial markets or the Fed might be contained if the attack is limited to air strikes or missiles launched from Navy destroyers. Analysts at Citigroup said on Wednesday that the likelihood of "meaningful supply disruptions" is low in the case of a strike.

The expectation has been that the process will start in September, according to a Reuters poll of economists earlier this month.

A delayed Fed move could temporarily boost emerging markets, traders said. But it may only just add a dose of volatility, because the reduction in purchases is seen as inevitable.

"Delaying tapering may get a short-term positive risk response, but would ultimately play out as even more risk negative," said Alan Ruskin, global head of foreign exchange strategy at Deutsche Bank in New York.

"Under these circumstances it is going to be hard for the Fed to indirectly support emerging market currencies, short of making it clear that tapering will be delayed for an extended period - which is not going to happen."

In such a scenario, a brief rally in emerging markets, should it happen, would likely be viewed as a chance for investors to sell more. Nations with big current account deficits - that is, those in need of external capital to support spending - are in a particularly precarious position.

One of those is India, where the rupee touched a record low against the dollar and the Bombay Sensex Index <.BSESN> has declined by 11 percent since July 23.

Syria's neighbor Turkey, already pummeled by an expected reduction in U.S. stimulus measures, has also been hit, with the lira hitting a record low against the dollar.

AUGUST PAYROLLS

Despite the rising tensions in Syria, some strategists said budget battles in Washington may be the more worrisome issue. The U.S. is expected to bump up against its federal debt limit in mid-October.

Treasury Secretary Jack Lew has said the Obama Administration will not negotiate spending cuts in exchange for an increase in the debt ceiling, while congressional Republicans hope to cut spending on social programs.

A bitter fight over the debt limit in 2011 led to the first-ever downgrade of the U.S. credit rating, and the prospect of a self-inflicted wound like a debt default could easily rattle markets.

"If the debt ceiling debate heats up to the point that it is seen by the Fed as creating the kind of uncertainty that dampens consumer confidence, and you see the price of oil escalate, further eroding confidence and consumer spending power, the Fed could announce a considerably smaller scaling back than initially planned," said Quincy Krosby, market strategist at Prudential Financial in Newark, New Jersey.

Congress will first need to pass legislation to continue funding the government or risk a shutdown in September, but market strategists are less concerned about this prospect.

A reduction of Fed support at the same time of political wrangling over budget issues could give investors pause about U.S. assets.

Some economists said next week's August U.S. unemployment report is the deciding factor. The Fed has said a reduction in stimulus is contingent on improvement in the U.S. economy and labor market. Recent housing and durable goods data have been disappointing.

"The most serious obstacle to a tapering of QE is the fact that the U.S. economy seems reluctant to show the sustained improvements the Fed is looking for," economists at Cornerstone Macro wrote in a research note on Wednesday.

"To deal with all the risks, the first step down is likely to be small of the order of $15 billion or so."

(Writing by Wanfeng Zhou; reporting by Gertrude Chavez-Dreyfuss, Steven C. Johnson, Rodrigo Campos, Richard Leong and Jeanine Prezioso in New York, Caren Bohan in Washington and Oliver Holmes and Erika Solomon in Beirut; Editing by David Gaffen and Leslie Gevirtz)

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