To Sustain The Rally, The Fed Should Start Tapering Now

by: Eric Parnell, CFA

The U.S. Federal Reserve has a unique window of opportunity, but it may only last for a limited time. It can begin tapering its aggressive monetary stimulus program without decimating the stock market averages it seems to value so much. By acting now instead of waiting until later, the Fed may actually increase the probability that the recent stock market rally can sustain itself into the longer term instead of completely falling apart like it already has several times in the past when the Fed has stepped away. In fact, the more aggressively the Fed tapers now, the more likely it may succeed in the end. Why? The Bank of Japan is now effectively doing the Fed's dirty work.

Thus far, the Fed's QE3 stimulus program has clearly achieved the goals of boosting stock prices (NYSEARCA:SPY) with the hopes of creating a wealth effect while also keeping borrowing costs low. The fact that this has occurred despite steadily deteriorating economic and market fundamentals makes it all the more notable and to many dubious. And these accomplishments have not come without significant cost and mounting risks. For example, the Fed has already aggressively expanded its balance sheet by $447 billion since the beginning of the year, bringing its overall size to $3.35 trillion to date, which represents a staggering fourfold increase since the outbreak of the financial crisis. If it continues at its current pace, the Fed's balance sheet will eclipse $4 trillion by the end of 2013. The more liquidity the Fed injects into the economy, the more complex and potentially painful the task becomes of eventually withdrawing it when the time comes. Thus, the sooner the Fed can begin to step aside the better.

Another complication associated with the Fed's balance sheet expansion is that it has become the primary driver of investment market activity. In fact, it has effectively become the only driver. The dialog surrounding investment markets is almost exclusively focused on what the Fed may or may not do next. Not only is this tremendously distorting and effectively undermines the efficient functioning of capital markets, it puts the Fed in a very tight box. For the moment the Fed begins to step away from its stimulus program, scores of investors and high frequency trading robots are likely to rush to the exits. Thus, if the Fed can find a way out while still supporting its goal of boosting asset prices and keeping interest rates low, it should seize it.

The recent actions by the Bank of Japan are presenting the Fed with the chance to pull off a great escape. Here's why.

The Fed's balance sheet expanding monetary stimulus program in QE3 was expanded to $85 billion in asset purchases per month with the addition of daily U.S. Treasury purchases at the beginning of 2013. But when the Fed first put the wheels in motion on its current program back in September 2012, it was the only major global central bank that was set to aggressively ease. The European Central Bank (ECB) was still offering nothing more than platitudes at the time and current Japanese Prime Minister Shinzo Abe had yet to win his runoff election. By November 2012, however, Abe had prevailed and was dialing up his rhetoric for bold stimulus measures including aggressive easing by the Bank of Japan. It was still unclear how daring the Bank of Japan (BOJ) was truly going to be until the beginning of April 2013 with the stunning announcement that the central bank would be doubling its money supply over the course of the next two years with liquidity injections totaling $75 billion per month, a program so aggressive relative to the size of the Japanese economy that it makes Fed Chairman Ben Bernanke look hawkish in comparison. So in short, the Fed's $85 billion per month stimulus program is now being effectively matched by the Bank of Japan's $75 billion per month program of its own. And a healthy share of this freshly minted Japanese liquidity is leaking its way into the U.S. and its financial markets as evidenced by recent moves in the yen (NYSEARCA:FXY) relative to the U.S. dollar (NYSEARCA:UUP).

Thus, this policy by the BOJ sets the Fed up with opportunity to continue pursuing their monetary policy objectives by free riding off another bank's liquidity injections while tapering their own program at the same time. This provides the Fed with a number of distinct advantages, even if many are only a matter of perception. Of course, perception is sometimes just as important as reality when it comes to banking and financial markets.

First, many investors are increasingly vocalizing frustration that the Fed is distorting financial markets through its seemingly endless and reactive policy interventions. By tapering now, it promotes the idea that the Fed is willing to stand back and allow financial markets to increasingly operate and set prices independently. This would potentially go a long way in helping to restore investor confidence in U.S. financial markets.

Second, many also worry that the Fed is already inflating a bubble in the stock market. But the moment the Fed demonstrates that it intends to follow through with tapering its stimulus program, the likely knee jerk reaction by investors and the high frequency trading computers is to sell the stock market off sharply, perhaps by -10% to -15% or more. But it could easily be argued that such a correction would actually be healthy, as it would demonstrate that stocks are not locked in a catatonic state and actually have the reflex to respond negatively to market events and move in a direction other than up. Such a pullback would also provide the opportunity for the many investors that were left behind by the stock market ramp up since last November to get on board if they so choose.

Third, the ongoing flow of stimulus money, albeit less, from the Fed coupled with the continued inflow of liquidity from Japan would likely put a floor under any stock market decline and resume pushing stock prices higher. For if we remain in a circumstance where at least $4 billion is being injected into global investment markets on any given trading day, it is likely to have the persistently positive impact on stock prices regardless of what specific central bank is printing the money.

Fourth, the Fed's decision to start tapering now would also likely have the positive spillover effect of lowering borrowing costs even further at least in the near term, as U.S. Treasuries (NYSEARCA:TLT) have performed considerably better during periods when the Fed is not directly applying balance sheet expanding stimulus to capital markets.

Lastly, in addition to reestablishing its credibility, it also provides the Fed with more flexibility to apply additional QE stimulus down the road if needed while also keeping the size of its balance sheet more under control in the meantime.

All of these advantages should have particular appeal to the Federal Reserve as they move toward their next meeting on June 18 and 19. This would be the prime opportunity to begin tapering and working to restore its damaged credibility with many market participants.

But it is also worthwhile to consider the potential consequences if the Fed opts to not taper and instead stays the course. Clearly, with the Japanese stock market (NYSEARCA:EWJ) having nearly doubled over the last six months and U.S. stocks having risen on an extraordinary 71% of trading days since the launch of the BOJ's stimulus program, the Fed is running the increasing risk of inflating a bubble in stocks that could quickly spiral out of control with a combined $160 billion per month pouring into the market each month. This is particularly true since all of these gains have come despite the weakening global economic and market backdrop. It should also not be overlooked that given the extraordinary magnitude of BOJ asset purchases that the risk of a major financial accident in Japan is rising by the day. Thus, while the Fed has the opportunity to pull off a move toward a gradual tapering now, global market conditions may eventually escalate or deteriorate over the coming months where the Fed and/or the Bank of Japan is ultimately forced to slam hard on the monetary brakes. And such actions would almost certainly have far more shocking effects on capital markets including their beloved stock markets.

For all of these reasons, it will remain worthwhile to listen closely to the words of various Fed members in the coming weeks for hints of tapering. While investment markets in the near term may not welcome the prospect of Fed tapering, such a move has the potential to restore some confidence, skim off some of the recent market froth and help support a more sustainable stock market rally in the medium term to long term. In the meantime, it remains worthwhile to maintain an allocation to stocks focused on high quality names that through discounted valuations, attractive current income and favorable technicals that have the better ability to hold their ground if not move higher with less downside risk whether the market continues to float higher on stimulus or suddenly enters into sharp short-term correction under a tapering scenario. Representative names include Exxon Mobil (NYSE:XOM), International Business Machines (NYSE:IBM), General Electric (NYSE:GE), McDonald's (NYSE:MCD), Oracle (NASDAQ:ORCL), Emerson Electric (NYSE:EMR), Qualcomm (NASDAQ:QCOM) and Cisco Systems (NASDAQ:CSCO). While the initial market response to any Fed tapering is bound to be turbulent, it would likely present a healthy opportunity to pick up additional high quality names at attractive entry points.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Disclosure: I am long CSCO, GE, XOM, MCD, IBM, QCOM, ORCL, EMR, TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.