We'd like to stop talking about the Federal Reserve so regularly. We really would. Unfortunately, we can't. The brave new world in which the stock market lives revolves around the Federal Reserve's monetary policy.
With the latter in mind, and considering there was a good bit of hoopla this week around the issue of the Fed tapering its asset purchases sooner than expected, we felt compelled to provide an addendum to our Fed piece from earlier this week, Stock Market Not Ready to Handle Tapering Truth.
The hoopla was borne out of Fed Chairman Bernanke's testimony before the Joint Economic Committee and the release of the minutes for the April 30-May 1 FOMC meeting on Wednesday. Each provided some headline fodder, yet neither provided new insight on the Fed's governing influence in making policy decisions.
Incoming data has been, is, and will be the determining factor for any adjustments to the Fed's asset purchase program and federal funds rate. Mr. Bernanke said as much in his prepared text and in the Q&A portion of his testimony. That message was clear in the minutes as well.
Based on the minutes, though, it was also clear that there was disagreement at the FOMC meeting as to how to interpret the data to determine when the Fed should taper its asset purchases. That is a bit concerning, because it highlights the growing nature of policy risk.
If the market had any reason to sell off like it did on Wednesday, we'd say that was it.
Letting Some Air Out
Our interpretation of Mr. Bernanke's testimony and the minutes was that they were both dovish in totality. Not surprisingly, though, the market's focus fell on a few lines that seemed to suggest a tapering of the Fed's asset purchase program could occur before this year's World Series is played (and won by some team other than the Cubs).
The first line of consternation came from the Fed chairman during the Q&A portion of his testimony. In response to a question as to whether the Fed might taper by Labor Day, Mr. Bernanke responded:
"If we see continued improvement and we have confidence that that's going to be sustained then we could in the next few meetings take a step down in our pace of purchases."
The second line of consternation, which was contained in the minutes, read as follows:
"A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, views differed about what evidence would be necessary and the likelihood of that outcome (emphasis our own)."
We'll cut to the chase and assert that we think the market used these references as an excuse to let some air out of an overheated rally. Bear in mind that the S&P 500 was up 13% for all of 2012. Entering Wednesday's trade, the S&P 500 was up 10% just from its low on April 18.
Ten percent in just over a month! The market was more than due to take a breather.
Will They or Won't They
This isn't the first time the stock market has dealt with the "will they-won't they" question. It prevailed in the first quarter when the stock market got off to a hot start, aided by better than expected economic data - but then the March employment report was released and concerns about the tapering question were tempered.
Those concerns were stoked again, however, in the wake of the April employment report that was released shortly after the last FOMC meeting.
Still, as we have noted before, a 7.5% unemployment rate that has been helped along by the lowest labor force participation rate in more than 30 years, and PCE inflation that is up 1.0% year-over-year, are not exactly data points providing evidence of sufficiently strong and sustained growth.
Anyone thinking the Fed will announce a tapering at the June meeting should think again.
Anything is possible after the June meeting, as the Fed chairman noted with his conditional response, but incoming data will drive that decision-making process. In that vein, it remains possible that the Fed could also increase its purchases in the next few meetings if the data support such a move.
There was no mistaking from the Fed chairman's testimony that the latter is still an option, yet the more worrisome angle of a possible tapering won out in the media.
What It All Means
If there was indeed true fear Wednesday about the Fed tapering soon, it goes to show that the market is not yet ready to handle the tapering truth. Any such angst is defensible given that the data do not support the case for tapering as laid out in the Federal Reserve's precept of looking for evidence of sufficiently strong and sustained growth.
Complicating matters, though, is the revelation in the minutes that views differed about what evidence would be necessary to support a tapering decision.
This gets back to the point we made in our May 6 article, Fed Policy as Easy as 1-2-3, and reiterated earlier this week in Stock Market Not Ready to Handle Tapering Truth, that the market isn't going to handle a tapering decision well if it is not convinced the Fed is meeting its own targets for satisfying its dual mandate.
It sounds as if FOMC participants are having their own difficulties reaching a consensus on what the necessary evidence is that will be used as a cue for a tapering decision. We won't say that there is debilitating dissension in the ranks, but there is perceptible dissension on both qualitative and quantitative matters.
The timing of a tapering decision will matter greatly for the stock market and the stakes are increasing the longer the Fed stays on a policy path that many FOMC participants still see as entirely defensible.
The FOMC needs to be particularly careful now about managing the market's expectations.
Policy risk was already high, yet it increased this week with the understanding that there is a growing chorus of differing views - and dare we say confusion - within the Fed on what evidence should be used to make a tapering decision and when.