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The Fed Taps Another Taper

31 January 2014 in Trading Ideas

Ready or not, the US central bank looks intent on steadily removing its foot from the gas.

For the second time in six weeks, the Federal Reserve announced earlier this week that it would scale back its bond-buying program – the so-called quantitative easing that the bank has undertaken in attempt to hold down long-term interest rates to spur borrowing, spending and investment.1

As it did six weeks ago, the Fed said it would trim its purchases of Treasury bonds and asset-backed securities by $10 billion a month – this time, down to $60 billion a month – while also suggesting that it would continue cutting the buys in increments of $10 billion in the months ahead.

Ironically or not, the Fed’s move came despite a glum performance by stocks so far in 2014, a tepid December jobs report and widespread selloffs in emerging markets. The S&P 500 is down 4% this year, dropping by 1% on Wednesday in the wake of the Fed’s announcement.

However, the Fed has declared itself more optimistic about the economy in recent months. We will find out next week if the December report job growth remains steady, or if unemployment concerns again take center stage. Meanwhile, the economy’s growth rate appears to have accelerated to well over 3% in the second half of 2013.

Fed Tapering motifOther obstacles facing an economic recovery, include financially strained households that can hinder consumer spending and restrictive tax and spending by the government. The Fed expects that GDP growth can be hold steady at 3% this year and rise above that level — without sparking inflation.

The Fed has reported that US economic growth “picked up” in recent months and was expected to continue at a “moderate pace.”

As Ian Shepherdson, chief economist at Pantheon Microeconomics, declared in a client note, the Fed’s path is all but set in stone: “The clear default position is that tapering will continue; it would take serious weakness or a real disaster to make the Fed pause.”

Because the Fed is easing off its intention to keep longer-term interest rates low, the expectation is that as the taper progresses, long-term rates will start to climb. In turn, the thinking goes, investors will be best served by pursuing asset classes that would be projected to perform well in a higher-rate environment.

That’s the thesis behind the Fed Tapering motif, a portfolio of stocks of regional banks with business models that could stand to benefit by having higher rates boost interest income.

The motif is down 4.8% in the past month, and is up 11.3% since it launched on September 3. 2013 The S&P 500 is off 4% in the last month and increased 10.5% since September..

That apparent disconnect so far in 2014 isn’t a disconnect at all – 10-year interest rates have actually fallen since going above 3% just before the end of last year, having risen more than 20% beginning in late October.

It’s worth noting that some analysts and pundits don’t anticipate a significant rise in interest rates anytime soon, even in the absence of the full-on Fed press, believing instead that the minimal inflation being experienced right now will endure and thereby keep rates in check.

Seemingly more certain is that even a string of mediocre job reports will unlikely deter the Fed’s current mode.

1Jon Hilsenrath and Victoria McGrane, “Fed Sticks to Script on Paring Bond Buys,” WSJ.com, Jan. 29, 2014.