The Fed met yesterday afternoon to discuss the state of the economy and decide if they would begin the process of tapering (i.e.; reducing its $85 billion per month asset purchase program). After a brief meeting, they decided to wait. Although a number of individuals were fully convinced the Fed would begin to taper this month, I have consistently written that the Fed would not begin tapering in September.
Why? Primarily because the U.S. economy remains weak and there are a few potentially significant risks in doing so. Of course, the time will come when the Fed will begin to reduce its asset purchases. How will this impact the financial markets? Perhaps more important, have the financial markets become so accustomed to the Feds easy money policy that the addiction is deeply ingrained? In other words, has the stock market consumed so much punch that the withdrawals will be severe?
It seems reasonable to assume that the actual process of tapering will be slow and gradual with the goal of minimizing any potential market disruptions. This is precisely where the difficulty resides. After all, everyone understands that the Fed cannot continue expanding the money supply at the current rate. Therefore, the key issue is to taper with the least amount of market disruption. I suspect this will include sending up trial balloons to gauge the market's reaction to various Fed actions, executing the tapering process, and having contingency plans in place to address any significant issues which may arise. In short, it will require a thorough PR campaign, but with much higher stakes.
Tapering And Higher Interest Rates
Most believe that tapering will result in an increase in interest rates, especially at the longer end of the yield curve. This could have two detrimental effects. The first would be higher mortgage rates. In this scenario, the housing recovery which is critical to a thriving economy, could slow drastically. Therefore, tapering at the present time would be risky. Another issue has to do with the federal budget. If tapering does indeed lead to higher interest rates, the increased cost to the federal budget would be a considerable impediment to fiscal policy health. I heard an interesting statistic recently that said that if interest rates were to rise by one percentage point, it would completely erase the budget savings created from the sequester.
Remember the sequester? If Congress didn't come to an agreement on the budget by a specified date, automatic budget cuts would ensue. Well, Congress did not and budget cuts were implemented. Again, a one percent rise in interest rates could effectively wipe this out.
Some speculate that any delay on the part of the Fed may be politically motivated as it would help the incumbent party by keeping interest rates low. Only a few people actually know the truth. The rest of us are left to speculate. Personally, I view this issue as one which affects the entire nation not just one political party. Sure, if the Fed did taper, and interest rates rose, and the housing market recovery stalled, and the federal government deficit and debt spiked, at election time, the Republicans would surely have all fingers pointed at the Democrats, and they may even gain seats in Congress.
However, if they couldn't pull off a victory in the last presidential election when the unemployment rate was at 8.2%, and given the fact that Obama was the first incumbent to be reelected when the unemployment rate was above 8.0% in the modern era, I'm not terribly confident that the Republicans would actually benefit. That said, if the federal government is forced to pay more to service its debt, it could have a detrimental effect on every taxpayer in this and future generations. For the record, I am very concerned with the amount of debt amassed by Presidents Obama and Bush. But the fact remains that higher rates will hurt everyone. Everyone except investors who rely on interest income.
A Final Word On Tapering
Even when the Fed actually begins to taper they will remain "highly accommodative." In essence, they will not raise short-term interest rates for quite some time. Recently, when the Fed merely hinted that they might begin to taper, stocks sold off sharply. The conclusion is that our economy remains weak, stocks are highly sensitive, and investors must remain cautious.
When will the Fed begin to taper? Some say December, but remember that's during the peak of the holiday season, a period when the economy typically does well. This "seasonality" makes it difficult to determine if the economy is really improving or just experiencing a Christmas boost. Therefore, even though it's quite possible the Fed will taper later this year, I don't believe they will until 2014.
Despite the fact that many U.S. stock markets are reaching record highs investors need to have a plan in place to protect against a sharp decline. Whether it's trailing stop orders, options, or some other hedge, we are not out of the woods quite yet. In the interim, with GDP under 2.0%, are stocks getting a little ahead of themselves? Perhaps. Which may be another reason investors need to keep a sharp eye on their risk assets and protect them in the event of a severe decline. Keep in mind that at some point the Fed will remove the punch bowl, the party will end, and the probability for a decline in stocks is high.
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