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Health & Fitness

David Joy: The tapering timeline

 

Halfway through the trading day on Monday, volume in the S&P 500 was 25% below its average over the past 100 days. We are truly into the dog days of summer. After two weeks of modest declines, stocks are meandering around their 50-day moving averages, looking for a signal as to what comes next.

The big scheduled news event of the week comes on Wednesday with the release of the minutes from the Fed’s July meeting. It might be recalled from the June meeting that the Fed raised some concern over rising mortgage rates and their implication for the recovery in housing, as well as acknowledging the disinflationary impulses in the economy. The latter seem to have receded somewhat since, but mortgage rates were even higher by the July meeting.

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Beyond that, the minutes offered little that was new and left investors to gauge for themselves when and how quickly the Fed might commence tapering. But, is the economy strong enough to justify the commencement of Fed tapering in September or October? If one adopts the Fed’s framework of cumulative improvement since the commencement of QE3, then the answer would seem to be yes. Last July the unemployment rate was 8.2% compared to 7.4% today. But if the benchmark is an acceleration in economic activity toward a second half growth rate of 2.5%, or higher, then the answer is less clear.

The data to start the third quarter has been a little better, but maybe not that much. Jobless claims, automobile sales and manufacturing seem to be improving, while housing has slowed somewhat, as have mortgage applications, apparently in response to higher rates, while job growth slowed in July. It seems that the Fed could use the data to justify whatever decision it chooses to make. Wall Street is betting that tapering commences after the September Federal Open Market Committee meeting, but we’ll have to wait and see.

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Tapering’s effect on Markets
So what happens to stock and bond prices after the September FOMC meeting? Have these markets fully priced in the expectation of tapering or not? Conversely, do prices rally if the Fed does not act? These questions are impossible to answer, but a few observations can be made.

First, the mild correction currently underway in stocks has trimmed a meager 3.4% from the S&P 500’s peak value. That hardly suggests that investors are terrified at the prospect of a change in Fed policy. Is the pullback so shallow thus far because tapering has been so well telegraphed? Is it because tapering should be considered a welcome development on the road to a normalization of rates? If it is either or both of these possibilities, then stocks seem to be looking beyond the issue of Fed tapering and saying that the economy is, at the very least, holding steady, and may be gaining traction. If so, earnings are also likely to accelerate and help to justify prices where they are, or even drive them higher.

Or could it be that, contrary to surveys, investors are skeptical that it will happen as early as September or October? If so, then another down leg in prices can be expected upon the event.

In contrast, the bond market seems far less conflicted. The yield on the ten-year Treasury note is now 125 basis points higher than it was back in May before Chairman Bernanke began to speak of tapering before year-end. And the last move higher has come just recently in response to stronger economic data. The Treasury bond market apparently sees the real possibility of less buying demand just as the appetite for credit may be accelerating. If so, then bond prices may have mostly discounted the Fed’s move, with perhaps a 3.00% yield as a reasonable target on the ten-year in the near-term. In the end, it may be that the issue of tapering is far more important to bond prices than to stocks prices, while economic data is important to both.

These dog days have a couple more weeks to run. Volumes can be expected to lighten further, while the reaction to news can be become heightened. Between now and Labor Day, there is a lot of data on the housing sector scheduled for release, but little else to further the debate. Labor Day week is a different story, starting with the August jobs report at the top of a long list of scheduled releases.

My weekly commentary will take a brief hiatus after today. Enjoy the final days of summer while they last. We may look back upon them fondly for their relative serenity.


Disclosure

The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

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