After all the hype in the lead up to today’s Fed meeting, the FOMC surprised markets in dramatic fashion this afternoon by keeping its bond buying program steady. I have argued extensively in this blog over the last 6 weeks that the underlying economic data did not support the case for tapering. Further, the impending budget/debt ceiling debates seemed to also be clear hurdles to a September taper. Nonetheless, the Fed continued its taper rhetoric and seemed intent on reducing its bond purchases in spite of the data. Against that backdrop, my central argument was that the Fed viewed the risks of continued QE as too high.
However, today’s news further complicates the investment landscape. As taper talk filtered through the markets, the prevailing view that began to take shape was that tapering signified a return to more sustainable growth. Thus, investors gradually became more comfortable with the idea and many saw it as a bullish sign. Yet, with the Fed standing pat, stocks are at record highs and the 10 yr is at 2.70. So how do you reconcile the “taper is good” logic with today’s rally when the Fed didn’t move? It seems as though “bad news is good news” again… especially in light of the fact that the Fed also downgraded its growth outlook. However, the worrying aspect of the lower growth outlook is not so much the news itself (the Fed has long since been more optimistic than the private sector), but rather the potential for an erosion of the FOMC’s credibility. After all, they presumably started the taper dialogue for a reason. And the prevailing view was that their reason was grounded in improved prospects for the economy. So today’s decision to lower their growth outlook suggests creates a whole host of other questions. First, the Fed may have been to quick to embark down the taper path in the beginning (ie. they overestimated the economy’s growth prospects). Or, the downgraded growth outlook could also be seen as reinforcing the argument that the Fed sees the risks of continued QE as becoming too high. That is, their initial reasoning for the taper was to lower systemic risk. If that was the case, then tapering has only be delayed. Either way, the Fed has left the markets confused in their attempt to broach the subject of unwinding QE. Therefore, today’s rally is likely not sustainable and should be taken with a grain of salt. To be sure, there was a lot of short covering.
Amid all of the TV banter floating around today, I have heard one very insightful explanation for the Fed’s decision from Brian Jacobsen of Wells Fargo Advisors. Jacobsen points out the numerous references the Fed has made to restrictive fiscal policy, both in today’s statement as well as in the lead up to the meeting. Given that Washington is soon set to begin the debt ceiling debate in earnest, it is very plausible that the Fed wanted to wait to see how those negotiations shake out before adjusting its policy. If true, tapering could well be back on the docket next month at the October meeting. Notably, given the Fed’s lower growth forecast today, this view is consistent with the idea that the original rationale for the taper discussion was heightened risk.
I still maintain that the fundamentals don’t warrant an immediate taper. Further, at these levels, valuations appear pretty full and thus I will continue to hold a larger than usual cash position until the risk/reward trade-off becomes more balanced or until the fundamentals confirm the valuations. In the meantime, I expect it to be a bumpy ride.
the commonsense capitalist 