Bernanke: Stimulus Pullback Coming!

Both equity and bond markets had been trading indecisively up and down for days leading up to this week’s FOMC meeting, hobbling back and forth between two possible outcomes.

Q.E. tapering or no Q.E. tapering – that was their question.

Investors finally got their answer on Wednesday, and both markets began running for cover. The S&P 500 index dropped 1.39%, while the 10-year Treasury note’s yield increased by 2 tenths of a percent to close at 2.365%.

Investors have begun repositioning their portfolios for the beginning of the end of Q.E.

FOMC Statement Highlights

Highlights from the June 19^th FOMC statement include:

• Economic activity has been expanding at a moderate pace; labor market conditions have shown improvement, but unemployment remains elevated; the housing sector has strengthened.
• The Committee sees the downside risks as having diminished; it anticipates inflation over the medium term likely will run at or below its 2% objective.
• The Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month, maintaining its existing policy of reinvesting principal payments in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, maintaining downward pressure on longer-term interest rates.
• The Committee is prepared to increase or reduce the pace of its monthly purchases to maintain appropriate policy accommodation as the outlook for labor or inflation changes.
• The Committee expects a highly accommodative stance of monetary policy for a considerable time after the asset purchase program ends; keeping the federal funds rate at 0 to ¼ % at least as long as the unemployment rate remains above 6.5% and inflation is no more than ½ % above the 2% longer-run goal.
• When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2%.

By the look of today’s official statement, nothing has changed at all. The Federal Reserve will continue to buy $85 billion worth of bonds and mortgage securities per month and will keep its bank lending rate at 0 to ¼ %.

While it mentions that low interest rates will continue for a “considerable time after the [monthly] asset purchase program ends”, it does not mention any time frame for ending that buying.

What is more, the statement reiterated that the Committee is “prepared to increase or reduce the pace of its purchases” as data changes.

So why the equity and bond sell-offs? Because of statements Chairman Bernanke made at the press conference following his reading of the FOMC statement. Though it is not yet time to include these comments into the official FOMC statement, the Chairman is nonetheless trying to prepare the markets for what lies ahead, like a weather person letting people know to get ready.

Bernanke Gives a ‘Heads-Up’

The commotion in stock and bond markets, including the sell-off in gold, came mostly after the FOMC’s statement, when Bernanke informed the press that the Committee “currently anticipates it would be appropriate to moderate the pace of [monthly bond] purchases later this year,” gradually phasing them out completely by mid 2014, as transcribed by Bloomberg Businessweek.

Many believe the “later this year” refers to the September FOMC meeting, a view shared by economists at Capital Economics in their note issued today as published by CBC Money Watch:

“Our best guess is that the Fed will wait until the September meeting and that even then the tapering will begin with a very modest reduction in the monthly purchases, to perhaps $65 billion per month.”

That’s an expected reduction of a mere 23.5%. Bernanke himself likened any upcoming reductions in bond purchases to simply “letting up a bit on the gas pedal.”

Bernanke stressed that the Fed will be closely watching economic growth, unemployment, and inflation in particular. Inflation is an important element in the Fed’s plans, directly affecting one of its two mandates: price stability. Loose monetary policy – including continued bond buying as needed – ensures price stability, not as in keeping them flat but rather stable, as in rising at a steady 2% annual rate.

However, if the projected inflation rate should ever fall below this annual target after bond purchasing is reduced, those monthly purchases could be increased once again. “Our policy is in no way predetermined and will depend on the incoming data and the outlook,” the Fed Chairman said. Bond purchases can be reduced or increased at any time, even as the FOMC statement has been announcing for months now.

Equities Will Remain Supported

So don’t let the sell-offs in equities and bonds terrify you out of all your holdings. The Fed may be preparing to let go of one hand (bond purchases), but it can always bring that hand back if the toddler (economy) starts to wobble.

As the Chairman confirmed at the press conference, “The key point is that our policies are tied to how the outlook evolves. That should provide some comfort to the markets because they’ll understand that we’ll be providing whatever support is necessary.”

Even so, the toddler is going to wobble in the immediate term. Both the equity and bond markets are long overdue for a healthy correction. According to the annual summertime pullback, U.S. indicies could retrace half of their gains of the past 11 months, falling perhaps another 10% from here.

Pocketing some profit now could set us up for a nice dollar-cost average play as we buy on any summertime dips. Or one may simply shift to the large-caps, which tend to fall less than the small and medium-caps.

Bond ETFs may be better avoided for the short term. The expectation of less government bond buying, even if it is still a few months away, will most likely cause further bond selling for now.

But don’t count bonds out forever. Some are predicting a slight rebound in bonds once the initial reaction to reduced Fed purchases is worked out of the bond market. After all, the rest of the Fed’s stimulus measures will still be in play for a few more years to come.

Once the anticipated reduction of Fed bond buying is washed out of current prices, likely by the end of the summer, markets should begin another impressive climb in the autumn toward new all-time highs in the first half of next year.

Joseph Cafariello

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