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3 Things to Fear More Than the Fed

Michael Santoli

Investors can never escape all fear and threat of loss. But as a start, it helps to know what’s worth being afraid of.

Atlantic Wire

In this market moment – with indexes clicking to new highs like an Alpine funicular along a steep slope of economic unease – too many are too afraid of the eventual scaling-back of the Fed’s $85 billion monthly bond-buying program. The "tapering" of the Fed’s liquidity efforts has become Wall Street shorthand for being weaned from the presumed source of market sustenance.

After chairman Ben Bernanke's testimony in Congress Wednesday morning, in which he reiterated that the Fed is in no hurry to change course, the minutes from the April FOMC meeting will be released. As Bespoke Investment Group points out, afternoons this year when the minutes have been disclosed have proven occasions for stocks to sell off on evidence that Fed officials are doing their jobs: weighing the pros and cons of reducing quantitative-easing measures earlier or later.

A relentless march

Certainly, the relentless upward march in the Standard & Poor’s 500 would seem to leave it exposed to any fair excuse for a sharp retrenchment, so taper chatter could prove a convenient one.

Yet tapering should not be investors’ main fear, for a couple of reasons. First, it doesn’t seem imminent. Investors typically over-anticipate pivots in Fed policy, but when someone promises to be late, he can usually be taken at his word. Bernanke has effectively vowed to wait until the economic strengthening trend is unequivocally in place before stepping back. New York Fed President William Dudley this week said policymakers would need three or four months’ worth of healthier economic numbers to begin the tapering process.

The quite-low inflation data lately have helped make this promise easier to keep, though frothy financial markets are a growing concern.

Then there’s the fact that any tapering will be gradual, reversible and clearly communicated. Arguably, the Treasury market is slowly adjusting, lifting 10-year bond yields toward 2%, which steepens the “yield curve” spread between short- and long-term rates. This is good for banks, whose shares have been leaders in the rally. The Fed’s direct role in sluicing money into stocks has almost certainly been overplayed. Its compression of interest rates and dampening of meltdown risks have prompted the hunt for return in riskier assets, for sure, but the monthly $85 billion in itself isn’t the main driver here.

So if “Don’t Fear the Taper” is the tune investors should be humming, then what should investors be more afraid of? Here are three potential hazards:

Another economic “soft patch.” The past three years, economic performance flagged in the spring and summer, sometimes accompanied by wobbling of European debt markets, causing growth to fall short of Fed forecasts.

For sure, the housing, auto and labor markets all look appreciably healthier in the U.S. this year than in 2011 and 2012. Yet the industrial index of purchasing managers, a key leading indicator, is weaker now than in the past two springs. Wages and hours worked are sluggish, and the sagging in commodity prices speaks of a global stall.

A serious “growth scare” is not the likeliest scenario. But because today it would be so unexpected, stocks are stretched so much higher, the Fed is already aggressive and the consumer savings rate has already declined, inklings of deceleration with little cushion beneath the economy could trigger a dramatic flight instinct by investors.

A “financial accident.” Global yields have been fabulously low for years, and institutions are feasting on risk assets and debt at a time when central banks – especially here and in Japan – are acting as large players in bond markets. High-yield bonds have record-low rates near 5%, and fringe borrowers such as the governments of Rwanda and Mongolia have sold debt cheaply to investors who bid for many times the amount offered. At some point such reaching for a bit of extra return builds danger into the system.

This combination raises the prospect of bouts of volatility causing some unforeseen rupture in the capital markets, the way seemingly isolated government debt and currency trouble upended huge hedge-fund trades in 1994 and 1998, not to mention the vaster scale of the 2000s mortgage crisis.

In particular, the Bank of Japan’s money-printing has spurred extreme jumpiness in Japanese government bonds, whose yields have doubled from 0.44% toward 0.9% in a month, causing officials there to vow to monitor market functioning closely.

A sense of invincibility. Should nothing come along soon to knock back investor expectations or cause the markets to correct lower, then the main thing to fear will be fearlessness itself.

Already, those who are involved in the markets are edging toward extreme levels of bullishness toward stocks, a sign that the relentless rally has engendered a feeling that the upside trade is almost ordained. The CNN Money Fear & Greed Index is pinned in the “extreme greed” zone. The weekly poll of financial advisers by Investors Intelligence shows the most lopsided optimistic consensus since April 2011.

Jason Geopfert of SentimenTrader.com, which follows measures of investor attitudes and behavior, wrote to clients Tuesday: “The persistency of the uptrend over the past few months has gone from impressive to remarkable to historical. In the process, it has defied all sorts of fundamental, technical and sentiment concerns that acted as barriers during previous uptrends, even over the past few years.”

He points out that a three-month gauge of the S&P 500’s upside persistence, based on a tendency to close near its daily high, reached an extreme seen only four other times in the past decade - each shortly before a stinging pullback. In the past 30 years, the only time it didn’t give way to a serious setback was in late 1995, during a “melt-up” rally that bears similarities with this one.

When it starts to seem too easy is when a strong uptrend based on reasonable analyses of relative asset valuations can morph into an outright asset bubble.

We’re not quite there but it’s time to get attuned to the clues.