All Eyes Are On the Federal Reserve – Published in Noozhawk on Monday, December 16, 2013

Economists, portfolio managers and investors are all watching for any indications from the Federal Reserve’s December meeting, which spans Tuesday and Wednesday of this week, that it may begin the tapering process sooner than March. Stock and bond market activity for the balance of 2013 and into 2014 will largely reflect the Fed’s stance regarding tapering.

Last week, three Fed governors indicated that they believe that tapering should begin sooner rather than later, and sooner than March. Nathan Foley-FisherJames Bullard and Jeffrey Lacker all made comments supporting tapering sooner, although Bullard is the only one of the three who has a vote on the FOMC (Federal Open Market Committee) — the body responsible for making the decision to taper, among other things. Bullard is calling for a small taper now, and this will likely be a point of debate if not contention at the meeting this week.

What Will an Early Taper Mean for the Markets?

The most likely reaction for stocks and bonds would be an immediate sell-off of some magnitude, probably 5 percent to 10 percent for stocks, and a bond market drop, which should push the 10-year treasury yield back above 3 percent.

While neither of these market moves would change the positive trends that have developed over the bull market rally, they could shake investor confidence somewhat. The increased volatility may stifle the influx of cash into these markets, and in particular into stocks, which has been the driving force behind the 26 percent-plus gains we have enjoyed in 2013 thus far.

Looking Ahead to 2014

Assuming the markets experienced a sell-off as described above, I would not expect to see a continued downside for stocks. If we experience a 10 percent correction, I would expect investors to view this as a buying opportunity, which would draw more cash into stocks in the short term. We should see a rebound, probably back close to the recent highs, and possibly even to a new, all-time high, to the 1,850 area for the S&P 500.

The tricky part will be deciding what to do after that initial rebound, especially if we hit fresh all-time highs. Valuations will be expensive as they are now, and there will be increased uncertainty surrounding the future growth prospects for the economy, and by extension, for corporate revenues and profits. If revenues and profits are not expected to grow sufficiently to support higher valuations, it will be difficult for stocks to continue making new highs. In this case, investors may get spooked, and may begin to pull their money out of stocks.

The probability of this occurring, and a subsequent, slow, painful slide in stocks, will depend in large part on the pace of tapering by the Fed. Should they choose to taper very slowly, the impact could be minimized, meaning that economic growth could be sustained, and stocks could hold up. If the pace of tapering is more aggressive, the Fed certainly runs the risk of stunting economic growth and causing a more pronounced sell-off in stocks, possibly pushing us into a bear market.

Change of Leadership

It will be interesting to see how the change from Ben Bernanke to Janet Yellen will impact the nature of the tapering process. Yellen appears to have similar views to those of Bernanke. However, each Fed chair has always had their own ideas about how Fed policies should be applied. The decision-making process at the Fed and FOMC does not happen in a vacuum.  Economic data is constantly changing and evolving, in real time, and changes by the Fed typically take two or more quarters to make a noticeable impact on the economy. This lag effect makes things extremely tricky for the Fed chair and the FOMC to make good decisions.

What hasn’t been discussed much of late is the Fed’s primary mechanism for impacting the economy — changes to short-term rates — the Fed Funds rate and the Discount rate. The Fed will likely begin adjusting these rates upward at or very near the time they begin removing stimulus from the economy through the tapering process. The combination of tapering and rising short-term rates will result in a shift of the entire yield curve across all maturities, which the curve also very likely steepening fairly dramatically. A rising overall curve with a steepening slope is a very difficult environment within which for stocks to generate positive performance.

With the Fed meeting beginning on Tuesday, we should begin to hear the tone of the discussions shortly. Market participants will be highly tuned in to any indications from the meeting as to the Fed’s intentions regarding tapering. Stock and bond market trading activity for the remainder of 2013 will largely depend on what we hear from this meeting.

Will we have a quiet end to 2013, or will the Fed make a surprise move to begin tapering right now, sending stocks and bonds south? We will know the answer soon enough!

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