The Fed's tapering should not be viewed as a reduction in their accommodative monetary policy; rather the Fed is anxious to return to a more normal posture in the financial markets and to regain flexibility of action necessary to respond appropriately to economic conditions. Historically (pre-QE) an accommodative Fed position in the market would be reflected in a steep positive yield curve. A positive yield curve is made up of lower short-term interest rates and higher long-term rates. In an effort to rebuild the demand of a devastated housing market; the Fed, through QE, has forced the curve flatter during a period of monetary accommodation, resulting in historically low nominal mortgage rates. Recent data does argue that the Fed's stimulus targeting housing has worked in spite of continued credit tightening by banks unwilling to lend. The current yield curve explains to a large extent banks' hesitation to lend. Banks generally borrow short and lend long. A relatively flat yield curve does not create incentives for banks to lend because spreads are too narrow. Indeed the traditional response to a restrictive money policy is a flat yield curve as the Fed seeks to cool the economy by reducing credit. So, during this recent emergency move described as quantitative easing (QE), the Fed has been working at cross purposes by targeting retail demand for mortgage, while reducing incentives for banks to lend. Returning to a more normal Fed posture will increase incentives to banks to lend without necessarily reducing demand in housing.
Under Greenspan, the Fed was highly successful in pulling the economy out of a severe financial crisis-led recession in the early 1990's by driving a significant curve steepening. Recognizing the need to rebuild bank capital levels, Chairman Greenspan reduced short term rates aggressively resulting in a 2-year bonds yield curve in excess of 360 basis points. Though the Fed forced a steeper yield curve it was accompanied by lower overall nominal rates. As a result banks had great incentive to lend, and borrowers were treated to then-attractive mortgage rates. Without spending U.S. taxpayers' dollars the Fed engineered a highly successful bank bailout as banks made impressive profits allowing them to rebuild capital levels. By 1994 the economy and banks had recovered sufficiently and the Fed had the flexibility to reverse the accommodation by increasing short rates, their principal tightening tool, and allowed the curve to flatten. In a QE environment the Fed can't move from an accommodation policy to tightening solely by increasing short rates. The move away from accommodation to tightening in a QE environment would be far more disruptive to the markets than what was witnessed over the last two weeks.
Going forward the yield curve will steepen quicker than the reduction in Fed bond purchases would imply, as the bond market regularly discounts the next couple of Fed moves. This is good news for the equity markets. A steep positive yield curve will continue to underpin the equity market with banks and financials stocks as leaders. Although an initial reaction may be for housing stocks to get hit; nominal rates will remain near historic lows thus continuing to support a robust housing market. This continued strength should translate to housing stocks as well. Indeed, the first reaction will be for sales of homes to increase as those on the fence jump to buy fearing greater mortgage rate increases.
Overall it is not the end of Fed accommodation. If, however, the economy does not improve as expected or takes a turn for the worse, then the Fed will respond by tapering the taper and possibly even reversing. Tightening, as evidenced by increased Fed Funds rate, will not occur until the Fed has stopped bond purchases and economic strength meets or exceeds the Fed's forecasts - likely not until well into 2015.
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. I have no business relationship with any company whose stock is mentioned in this article.