SATURDAY, SEPTEMBER 14, 2013
Bernanke's Swan Song
By KOPIN TAN
Can the Fed chairman put us back on the path to normal?
This week, the markets' reputation for anticipation will be put to the test.
Will the Federal Reserve begin scaling back its easy-money stimulus? The market seems to think so. Investors have been paring back bonds susceptible to rising interest rates, and the 10-year Treasury yield has already jumped this summer from 1.6% to nearly 3%, far faster than the pace of economic improvement. Last week, a Wall Street Journal survey of 47 economists found that two out of three think the Fed will begin tapering after Wednesday's policy powwow.
Ideally, the Fed should cut back its monetary medicine only after our fitfully recovering economy is strong enough to leap tall buildings in a single bound. But there are reasons not to wait until Miley Cyrus—last seen swinging naked from a wrecking ball—is old enough to buy a beer (which she will be Nov. 23—watch out!). Since the Fed began buying $45 billion of Treasuries and $40 billion of mortgage securities every month, our unemployment rate has fallen from 8.1% to 7.3% and 2.2 million jobs have been created. That's "significant cumulative progress" toward the Fed's objectives, notes Joseph Kalish, Ned Davis Research's chief global macro strategist. The effectiveness of further bond-buying in stimulating our economy also is debatable, and the Fed won't want to inflate new bubbles. Besides, Ben Bernanke might want to put us back on the path to normal before he retires early next year.
Clearly, the market thinks—or hopes—any stimulus reduction will be small and data-dependent, which is why stocks are crouching expectantly just 1.3% below all-time highs. Phil Camporeale, executive director at J.P. Morgan Asset Management, thinks the Fed will reduce monthly purchases from $85 billion to $70 billion or $75 billion. Mindful of how rising mortgage rates can undermine the housing recovery, Kalish thinks the Fed will cut Treasuries buying by $10 billion and mortgages by just $5 billion.
Already, risky stocks outperformed during August's pullback, and they continue to thrive now as the market turns higher. Since late-August, the 50 largest stocks within the Standard & Poor's 500 have gained just 3.2%, but the 50 smallest jumped 5.3%, notes Bespoke Investment Group. Stocks paying the richest dividends rose just 0.5%, while those offering no yield surged 5.5%. Heavily shorted stocks outperformed, as did those sporting the richest valuations.
Are stock buyers hoovering up risk because they aren't afraid of unruly interest rates? On the contrary, August marked the first time in six years when the paths of the S&P 500 and the 10-year yield diverged, with stocks retreating while yields climbed. "Normally, rising rates are not a problem for stocks until the 10-year yield gets above 5%," when inflation becomes a peskier problem, notes Jeffrey Kleintop, LPL Financial's chief market strategist. "But the pace at which yields head higher matters at any level."
So why are stocks rallying? Economic growth is picking up, and Wall Street hopes Fed tapering is increasingly priced in, and that the steepest rate surge is already behind us. Rising yields on five-year, 10-year, and 30-year Treasuries have stopped just shy of 2%, 3%, and 4%, respectively. If they breach these round-number thresholds with gusto, hold your hat.
Not everyone agrees with the consensus huddle. Ethan Harris, Bank of America Merrill Lynch's economist, thinks there's a 55% chance the Fed won't taper in September, and a 30% likelihood the Fed might taper by just $10 billion to $15 billion. Frank Beck, chief investment advisor at Beck Capital Management, thinks the Fed might be better off cutting monthly bond-buying by a tiny but steady amount each month until we reach zero—for instance, buying $4.25 billion less each month over 20 months. After all, announcing a new level of bond-buying, say, $70 billion each month, merely keeps investors guessing before future Fed meetings and anxious about how the program will change again. "We'll have the same guessing game, and the resultant volatility in the markets," Beck says. In contrast, a small incremental monthly reduction maps out the path back to normal, letting investors adjust to that pace, "and debt, equity, and emerging markets could start acting on fundamentals again."