Federal Reserve inspires new confidence in stocks and bonds

The Federal Reserve, in delicately announcing the start of its tapering program, has masterfully inspired confidence in both the stock and bond markets.
After frustrating the market with a head-fake no-taper announcement in September, the Fed on Wednesday laid out plans for a $10 billion reduction of its $85 billion monthly bond buying program that has pushed the Fed’s balance sheet to beyond $4 trillion.
The equity markets, which had been fretting the notion of tapering as a death knell to the five-year market rally, jumped on the wording of the announcement as positive.
After dipping initially in response to the report, stock prices spiked in a display of confidence related to the Fed’s reminder that it has no plans to raise interest rates anytime soon.
“The two things that the market liked about the Fed announcement are that the reduction in bond purchases is pretty modest, and the Fed reaffirmed it zero-interest-rate policy,” said Dan Veru, chief investment officer at Palisade Capital Management.
“I would have been surprised if they just said they were tapering and then said nothing else, but this kind of announcement didn’t really surprise me,” he added. “They went out of their way to emphasize that the Fed will remain extremely accommodative.”
While some market watchers essentially took tapering off the table until after Fed Chairman Ben Bernanke is replaced on Feb. 1 by Vice Chairman Janet Yellen, the taper decision is now being interpreted as a clear sign that the economy is strong enough to start standing on its own.
Even though any reduction in the five-plus-year quantitative easing should be seen as a sign of economic strength, investors of all stripes were concerned that the market would panic as soon as the Fed pulled back on a program that was widely seen as helping to fuel the stock market’s bull run that has the S&P 500 index up 25% for the year.
“From a real economic perspective, this is a positive step,” said Brad McMillan, chief investor officer of Commonwealth Financial Network.
“I expected more of a negative reaction from the market, and I do question whether this is a sell-the-rumor-buy-the-news move,” he added. “But I think over the next few weeks we’ll see the market push to new highs.”
Burt White, chief investment officer at LPL Financial Services, said if the market was surprised by the announcement, it was a pleasant surprise, particularly for Treasury bonds, which seemed to hold steady while stocks rallied.
“A lot of people got sort of confused about the difference between tapering and tightening, but now it seems people are starting to understand the viewpoint that even with tapering we’ll have rates lower for longer,” he said. “We might actually see an environment where stocks go higher and bonds hang in there in a kind of goldilocks rally.”

Mr. White said the Fed “figured out a way to taper without being bearish” through some key wording that might have actually raised the Fed’s threshold for eventually raising interest rates.
“The Fed changed its trigger for raising rates from an unemployment rate of 6.5% to at least 6.5%,” he said.
The subtlety of the language is no small point, according to Mr. White, who believes the Fed deliberately introduced some new leeway in the monetary policy.
“What surprised me is how bullishly confident the Fed was in its statement,” he said. “The market has been focused on whether the Fed was hawkish or dovish, but it should have been focusing on whether they were bullish.”
The Dow Jones Industrial Average gained nearly 300 points after the Fed’s afternoon announcement. The 10-year Treasury yield gained four basis points to reach 2.88%, showing that the bond market remained relatively calm.
“Clearly, the market liked this announcement, and I think it also helps the Fed get some credibility back,” said Doug Coté, chief investment strategist at ING U.S. Investment Management.
“I think this is all part of getting us back to normal,” he added. “This clearly passes the mantle for the growth of the economy back to the market and back to fundamentals, which are truly in control now and they will have to sustain themselves.”