Dancing To The Tune Of The Fed

Includes: SPY
by: Fletcher Greer

Although targeted with criticism for the easy money that has persisted for the last few years, the expansionary policies of the Federal Open Market Committee have 'worked.' It's true, the bond purchases did not move the economy to full employment since their inception, but they have had a fabulous impact on asset prices. In the 100th year of the Fed's operation, domestic equity markets have seen impressive returns and inflation has continued at a pace below 2% threshold. Given the now infamous adage of "don't fight the Fed," the market has been incredibly responsive to central bank announcements. With the exceptions of concerns during to sovereign debt crisis and some election flutters, the market has been in great shape since the first quarter of 2009. Bond purchases by the Fed have reduced interest rates to historic lows, pushing yield starved investors into riskier assets, such as equities and real estate. This year, Standard & Poor's 500 Index (NYSEARCA:SPY) is up 15%, consumer confidence is up, and federal budget deficits are shrinking. On the surface, this seems fantastic. But alas, the monetary stimulus injected into the American Economy by Ben Bernanke can't continue forever: there will come a time when the asset purchases will stop.

Back in 2012, the Federal Open Market Committee stated that they would continue to follow the dual mandate of maximum employment and price stability. In 2012 the FOMC announced that it would continue to purchase mortgage-backed securities and at its current pace, and purchase additional treasuries. They predicted that inflation would continue to run at or below 2% in the medium term, suggesting that their bond purchases will put extensive pressure on prices. Furthermore, the committee maintained that the federal funds rate ranging from 0-25bps would continue to hold so long as unemployment remains above 6.5%. While this threshold doesn't seem like it would be crossed in this Friday's BLS employment report, each new employment survey by the Bureau of Labor Statistics presents an opportunity to cross this threshold. The first Friday of every month has become the opportunity for the Fed's magic number to manifest, and for the deluge of stimulus to stop flowing.

A 6.5% unemployment rate would be the lowest reported since October of 2008, and a clear signal that the economy was once again an engine of prosperity. Unfortunately for investors, this rather positive indication could spell headwinds for financial markets. As the Fed sees its target met, the FOMC would be inclined to begin to wind down its asset purchases. This would begin to cause outflows, and an increase in interest rates. The higher yield environment would cause bond prices to fall, and for bonds to become more attractive, relative to equities: inciting portfolio rebalancing toward bonds and away from stocks. This would naturally cause declines in stock prices in the short term.

While one might be critical of this opinion, saying that I am far too optimistic to expect unemployment rates to fall to 6.5%, it should be noted that GDP growth is anticipated to accelerate to 3% in 2014, which would become the greatest rate of expansion since 2005. If GDP is expected to continue to accelerate the economy should gravitate toward full employment. Unemployment has been trending down since 2010, and it appears that that will continue, notwithstanding major shocks. As has been noted before, the recovery from the "Great Recession" has been notoriously slow, but relatively consistent.

Remember, although a pleasant employment data surprise indicates sound economic recovery, its impact on FOMC policy should not be underestimated. Remember: Don't fight the Fed.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.