Is The Fed Setting Wall Street Up For A Rough Ride?

 |  Includes: DIA, IVV, QQQ, SPY, VOO, VXX
by: BubbleBustInvesting

Another Fed meeting, another confirmation that QE will remain intact as far as the eye can see. In a statement released this afternoon, the Fed re-affirmed its commitment to buy $45 billion of mortgage securities, and another $40 billion in US Treasuries. As long as the labor market remains weak, that is, as long as the unemployment rate remains above the natural rate of 6.6 percent; and core inflation remains below 2 percent.

In other words, monetary policy will continue to be data-driven - as it is supposed to be.

This explicit disclaimer sets Wall Street on a course for a rough ride, should either unemployment drop sharply or inflation rises rapidly. In that case, the Fed has to act swiftly or risk a credibility problem. Either way, debt and equity markets could be in for a rough correction, especially the interest rate sensitive sectors, like homebuilders and high-dividend paying stocks.

When would that come into play?

Nobody can say for sure, but we'll get an idea on Friday from data published from the Labor Department on July payroll and household surveys. Markets expect 183,000 new jobs for July, down from 195,000 in June. Markets will also look at the composition of this data (private jobs versus government jobs). And all eyes will be on the unemployment rate. Here the expectation is for 7.5 percent, down from 7.6 percent in the previous month. A rate well below 7.5 percent could unsettle markets, as it will raise fears that "tapering" will come sooner than later, while a number well above the 7.5 percent could fuel fears of another recession.

What should investors do? A number of things: First, raise some cash by trimming positions in interest sensitive stocks. Second, trim positions in high-flying momentum stocks, as momentum stocks usually suffer the largest losses when interest rates begin to rise. Third, buy some insurance, e.g., puts on PowerShares (NASDAQ:QQQ), and SPDR S&P 500 (NYSEARCA:SPY) or the iPath S&P 500 VIX (NYSEARCA:VXX).

Disclosure: I am long QQQ. 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.

Additional disclosure: Short on SPY with options