This week, we should finally get clarity on the issue investors have been obsessed with since May -- when and how the Federal Reserve (Fed) will start to adjust monetary policy. My best guess is that the Fed will announce a modest reduction, what I'm calling a "taper lite," in the size of its monthly asset purchase program at its meeting this Wednesday. I foresee the Fed saying that it will begin reducing its monthly asset purchases by $10 billion to $15 billion. That would lower its total monthly asset purchases to a range of $75 billion to $70 billion.
Why don't I expect a larger reduction? As I write in my latest weekly commentary, there are two reasons I expect a gradual taper:
- The almost total lack of any inflationary pressures outside of oil. The Fed has considerable latitude to go slowly as inflation remains contained, most evident last week in August producer price data. If you take out the more volatile food and energy components, producer inflation fell to 1.1% year over year in August, the lowest level since the summer of 2010.
- The U.S. economic recovery is still uneven. Job growth has not accelerated and as a result, both wages and consumption remain soft, as evident in August's relatively weak retail sales data. Of even more concern is the housing market. The low rates that have fueled the economic recovery are becoming a thing of the past. Mortgage rates are now at 4.8%, up from 3.5% in May, and the higher rates have already had some negative impact on housing activity and have eviscerated the refinancing market. Given the dynamic between interest rates and housing, the Fed will want to prevent too steep of a rise in yields lest this put the housing recovery in jeopardy.
So what does this mean for investors? Markets are likely to remain volatile in the near term as investors will be closely watching for any qualitative guidance around when the Fed intends to raise short-term rates. However, in terms of tapering I believe that the impact of a gradual reduction in the rate of monthly purchases is already reflected in bond prices. This suggests that absent stronger economic data, long-term rates are likely to be contained for the foreseeable future. This backdrop presents a couple potential near-term opportunities for tactical investors with a short-term horizon:
- Consider high yield bonds, which would benefit from an environment of stable rates and a slowly improving economy.
- Consider emerging market (EM) equities. This asset class has suffered in recent quarters as higher rates and a stronger dollar have put pressure on many of the EM currencies. A more stable rate environment, however, suggests better performance for EM equities.