Fed Tapers Matter

Over the past few years, we’ve all come to know the phrase “Black Lives Matter.” And regardless of what you might think about the organization of the same name (I have distinctive thoughts, but that’s for another time), one thing that must be said is that they did come up with a positive branding hook with the name. In fact, the name is so catchy that others have modified it to say, “Blue Lives Matter” and “All Lives Matter.”

Now, I have my own spin on this phrase, and I apply it to various aspects of life. “Rational Lives Matter” is my main motto, as that reflects my reverence for reason as man’s primary tool of survival. Then there’s “Nine Lives Matter,” which expresses my love of felines, and particularly Persian cats. Yet because so much of my own life is dominated by the financial markets, I now have come up with a spin on the phrase, and that spin is “Fed Tapers Matter.” 

You see, when it comes to the Federal Reserve and its current bond-buying program, also known as quantitative easing (QE), the consensus is that “tapering” of its bond purchases is going to begin very soon. Yet what really matters here is not when the Fed tapers, but how the Fed tapers. Stated differently, “Fed Tapers Matter.” Allow me to explain. 

Today, I am going to share an excerpt from my daily morning intelligence briefing, the “Eagle Eye Opener.” This is from the Tuesday, Aug. 24, edition, and I wanted to share it with you because I think it shows you the level of insightful analysis you get each trading day. 

Now, as much as I would like to take full credit for this analysis, I cannot. That’s because the “Eagle Eye Opener” is a joint venture between me and my “secret market insider,” a man who provides this same insight to thousands of high-profile market professionals each morning. So, we (if you’re a subscriber) get to benefit from the same morning intelligence briefing that the “big boys” do, and we get it in our Inbox at 8 a.m. EST each trading day. 

So, let’s dig right into the analysis of why “Fed Tapers Matter.”  

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The S&P 500 and Nasdaq both hit new all-time highs on Monday, and if there was a “reason” for the rally, it’s growing sense that the Fed won’t taper as aggressively as some had feared just a few weeks back.  

This idea has been percolating with investors since midweek last week (it was also why stocks rallied on Friday) but the announcement Monday morning that the Jackson Hole Central Bank Conference would have increased COVID-19 mitigation procedures and that Federal Reserve Chairman Jerome Powell would give his speech virtually drove home the point that the Fed has noted the spike in COVID-19 cases and the Delta-inspired headwind on the economy (albeit a mild headwind for now).

Those changes prompted the market to begin to anticipate a “dovish” Powell at Friday’s Jackson Hole speech, so given this influence we want to lay out a “Good, Bad and Ugly” scenario analysis for tapering, so we know what the market will likely do depending on Powell’s speech. Now to be clear, we don’t expect Powell to give any specifics on tapering Friday, but he should clearly “warn” the market that it’s coming. The key will be whether he stresses how gradual tapering will be.  

“The Good Taper.” The Fed begins tapering in December and at $5 billion or $10 billion/month, essentially leaving QE ongoing for most (or all) of 2022. Likely Market Reaction: Risk on. The market is still viewing the Delta variant and COVID-19 spike as a temporary influence, so if the Fed tapered more slowly in response to it that would create an environment where the economic recovery resumes as COVID-19 peaks, but it’d still have the tailwind of QE for basically all of 2022. I’d expect stocks to rally (the S&P 500 could push towards 4,750 or higher as multiples could expand) led by cyclicals and growth/commodities. Treasury yields would rise but not materially given the Fed will continue to buy Treasuries throughout 2022. But I’d still expect the 10-year yield to hit 2% in the coming quarters. The dollar would drop sharply (likely through 92) while commodities would be the biggest winners from this decision (oil and gold should surge on the weaker dollar and higher sustainable inflation).  

The “Bad Taper.” The Fed does as expected and begins tapering in December at a rate of $15 billion/month, ending QE in mid 2022. This outcome isn’t really “bad” because it’s already mostly priced into markets, but with COVID-19 cases high again and some rising concerns about growth, the market would be more sensitive to the Fed following this procedure. But as long as the market views the COVID-19 spike as temporary (and it still very much does) then this tapering schedule won’t derail the rally. Likely Market Reaction: Not much. Stocks could drop modestly on a knee-jerk “tapering is bad” tantrum, but again, this has been widely telegraphed so I wouldn’t expect too big of a move. Defensives and super-cap tech would outperform cyclicals and value. Treasury yields should rise back into the upper 1.50% range on this outcome in the coming months, although again I don’t think the increase in the 10-year yield would be “disorderly.” The dollar shouldn’t move much, as at 93 this outcome is already priced in, and the same can likely be said for commodities (again they are off recent highs, and this is largely priced in).    

The “Ugly Taper.” The Fed begins tapering QE in December at a rate of $30 billion/month (or more than $15 billion), ending QE before June 2022. This would be a shock to markets and substantially increase stagflation concerns, because the Fed aggressively tapering QE with the uptick in COVID-19 cases would clearly signal that the Fed is nervous about inflation regardless of the loss of growth. Likely Market Reaction: Pain. Stocks would drop sharply led by cyclical sectors such as energy, materials, and consumer discretionary. Super-cap tech, consumer staples and some financials (benefitting from higher rates) would relatively outperform but the entire market would be sharply lower. Treasuries would drop/yields would surge (10-year yield likely towards 2%), as would the dollar (the Dollar Index would rise towards 95). Commodities would be the biggest loser in this scenario and gold would get hit very, very hard.  

Would a “No Taper” Be Good for Stocks? No (at least not beyond the very short term). Markets might be inclined to think a total delay of tapering would be good for stocks, but that’s not likely the case beyond an initial (dovish is good) pop in markets. I say that because sustainably high inflation is much, much bigger medium- and long-term risk to stocks than COVID-19 (as long as the vaccines hold the line), because too-high inflation will ultimately result in the Fed hiking rates more quickly and crushing the economy (see 1970/early 1980). In the meantime, assets could rise but corporate margins would continue to get squeezed. Bottom line, a tapering delay would spark a short-term rally, but we’d be looking to get majorly defensive after that initial pop. Keeping inflation under control is much more important for the long-term health of the bull market than anything else.  

How the Fed tapers is the next major variable for this market (again assuming the COVID-19 cases do subside like they have in India and the UK) and how the Fed tapers will dictate whether that’s a tailwind or a headwind for stocks. Again, we do not expect these specifics to be announced on Friday. They will come at the September meeting. But we do expect Powell to hint at an outcome and given the Fed’s changes to the conference (masks, more social distancing, Powell virtual), if there’s going to be a surprise it’s likely dovish.  

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Well, there you have it. This is the kind of masterful, high-level market analysis you will find each and every morning when you subscribe to the Eagle Eye Opener. So, if you want the kind of market intelligence that the pros get every morning, and at a cost of about one nice dinner every quarter, then I invite you to check it the Eagle Eye Opener right now — it might just be the best decision you’ve made all summer. 

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Locke’s Fence 

“The only fence against the world is a thorough knowledge of it.”

— John Locke

I already told you that one of my main mottos has become “Rational Lives Matter.” Well, the philosopher John Locke would likely have agreed. I say that because, in his famous quote here, Locke stresses knowledge of the world as one’s only “fence,” i.e. one’s only protection from the chaos that reality can sometimes bring about. Another way of putting this is that the more you know, the better equipped you are to prevail — and I love that!

Wisdom about money, investing and life can be found anywhere. If you have a good quote that you’d like me to share with your fellow readers, send it to me, along with any comments, questions and suggestions you have about my newsletters, seminars or anything else. Click here to ask Jim.