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Changing Fed Stance Means More Stock Volatility

Richard Cox

NEW YORK ( TheStreet) -- The month of June has brought sharp selloffs to stock markets, with the downside momentum propelled largely by changing expectations for the Federal Reserve's monthly bond-buying programs. As a result, the S&P 500 has fallen more than 3% from its all-time highs, posted on May 21. Some sections of the market now expect the Fed to begin phasing-out its third round of quantitative easing as early as September.

As economic surveys continue to indicate stabilization and recovery, these predictions become more and more likely. Because of this, central bank comments have increased in importance in recent weeks as analysts look for clues to assess the timing of the Fed's next move.

At its most recent monetary policy meeting, the Federal Open Market Committee (FOMC) did reiterate its intention to continue purchasing $85 billion in bonds each month and to maintain near-zero interest rates as long as the jobless rate holds above 6.5%. But these latest bear moves in the benchmark stock indices show investors have their doubts, and that the Fed is ready to alter its policy stance.

Beige Book Shows Stable Growth

The latest sign of economic stability came with this week's Beige Book release, which showed "modest to moderate" growth in 11 of the 12 Federal Reserve districts. Areas of strength could be seen in construction, manufacturing and business services.

Growth in hiring rates was another bright spot in several districts, along with improvements in consumer spending (on gains in automobile purchases). Market reaction to the story was bearish, however, as this lends credence to the argument that the Fed can start to scale back its stimulus programs.

Internally, the Fed debate continues. Kansas City Fed President Esther George has dissented at the last three monetary policy meetings, saying the central bank should slow the pace of its bond purchases. John Williams, head of the San Francisco Fed, has suggested that we could see downward adjustments in bond purchases before September. Atlanta Fed President Dennis Lockhart has shown less confidence, saying that economic data has yet to show enough consistency to warrant a change in stimulus policy.

Next Clues in Jobs Data

Given these factors, Friday's nonfarm payrolls report takes on a higher level of importance. The highly-correlated ADP private employment report came in lower than consensus estimates, matching the weakening trends seen in the employment component of this month's Institute of Supply Management (ISM) survey.

So far this year, monthly nonfarm payrolls have come in at an average of 195,000 jobs. This average is well above the expectation for this month's expected number (a gain of 165,000 jobs).

This week's data will be pivotal in determining the near-term direction of both stock values and perceived expectations for any changes in the Federal Reserve's policy stance.

While the summer months are typically characterized by declines in market volatility, there is real potential for the activity seen this year to be different as there is enough evidence to suggest the Fed is at a major inflection point and ready to signal changes in its historic quantitative easing program.

With prices holding within striking distance of all-time highs in both the Dow and S&P 500, there is still risk for substantial downside corrections if the next round of employment figures are encouraging.

Increases in volatility become more likely if this is the case as investors will re-position themselves in preparation for expected declines in corporate earnings. Even with the declines seen in recent weeks, the S&P has still managed to post gains of nearly 15% year-to-date. But if the majority opinion at the Federal Reserve shows a bias toward major policy changes, a central pillar supporting this rally will be removed and deeper downside corrections in stock values are likely.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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