With a potential military strike on Syria moving to the back of investors' minds, Wall Street is forced to deal with the prospect of the Federal Reserve cutting back on its quantitative easing program later this month. Currently the Fed is buying $85 billion a month in its ongoing effort to keep rates at or near 0%. The Fed has signaled its intention to reduce ("taper") these purchases; the only questions are by how much and what will happen?
Paul Hickey of the Bespoke Investment Group thinks the equity markets are adjusting to the notion of tapering just fine. Despite the recent headline risk from Syria stocks have been reacting well in response to positive news. That marks a change from the "good is bad" thinking of the last few years when the perception was that the Fed was the only thing holding stocks higher.
The bond market is a different story. The yield on 10-year (^TNX) notes have moved from 1.63% at the end of May to just under 3% last week. The Fed may be talking about its commitment to gradual tapering but in the bond world it's all about future prices. While stocks play Hamlet trying to decide whether the bull is to be or not to be, the bond pits have decided the rally is over and it's time to take yields higher.
Part of the bond market's caution stems from the fact that we're in uncharted territory. There's never been anything even close to what the Fed is trying to do in terms of unwinding the massive quantitative easing program. The FOMC may have the best intentions when it comes to gradually easing, but the central bank's actual control of the market is limited. Yields have spiked more than 40% merely on the idea of a reduction in stimulus. There's no telling what kind of world we'll be in once the buying actually stops.
Though the economy has yet to reach the Fed's stated goal of 6.5% unemployment, Hickey says other data supports the notion of higher rates. Pointing to the Institute of Supply Management data released last week Hickey says interest rates have been much higher than they are currently under similar economic conditions.
What's it mean for later this month? Most likely the Fed will taper by an amount designed to appease market participants more than change fundamentals. Look for a $10 to $20 billion reduction in purchases later this month.
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