The Fed could reverse easy policy soon. Here's what tapering means for stocks

Published Thu, Aug 12 20213:38 PM EDTUpdated Thu, Aug 12 20216:17 PM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

There are clear signals from some Federal Reserve officials that they support tapering the central bank's bond purchases soon, but that may not trigger the shock waves across the stock market that some investors fear. There could still be some ripples as the Fed moves towards slowing its bond buying, but strategists do not necessarily expect it to be the trigger for another "taper tantrum." The taper tantrum is the name given a 5% sell-off which was set off when the Fed moved to curb its quantitative easing program in 2013. Instead, the move higher in interest rates could parallel a rise in cyclical and value stocks that do better on positive economic news. "If the Fed, in particular this Fed, finally does decide it needs to taper, holy cow! The economy must be great," Leuthold Group CIO James Paulsen said. "If they decide to taper it, must be fundamentally good. ... If the Fed actually showed some confidence that this economy was good, and it could stand on its own two feet, you might see a cyclical, small-cap rally." Paulsen noted that cyclicals have been moving higher in the past week. For the week-to-date, financials are up 2.6%, materials have gained 2.6% and industrial stocks are up 1.7%. Tech has been a laggard, down 0.5%, and it often takes a back seat when interest rates rise. The 10-year Treasury yield, which moves opposite price, has moved from a low of 1.12% on Aug. 4 to 1.36% Thursday afternoon. The small-cap Russell 2000 is slightly lower and flattish week-to-date, while the S & P 500 is up a half percent. The 10-year's rise started last week after Fed Vice Chairman Richard Clarida said he supported a move away from easy policy if the economy improves. There was also a very strong jobs report, showing 943,000 payrolls added in July, that helped lift yields and gave the market more confidence that the labor market is healing. The yield's continued move higher this week coincided with more comments from a parade of Fed officials who have thrown their support behind tapering their $120 billion a month bond program. Some have done so aggressively, like Dallas Fed President Rob Kaplan, who said on CNBC the central bank should announce the taper in September and start cutting back bond buying in October. Others, like Chicago Fed President Charles Evans, are more dovish and want to see a few more strong monthly jobs reports first. "I think that sort of illustrates the divergent dovishness and hawkishness of the members," said Randy Frederick, Charles Schwab managing director of trading and derivatives. "When we get to the summit in Jackson Hole, we'll probably get some clearer messages than what we've got so far, and that it's not too far out." Wall Street expects Fed officials to provide more detail about the taper when they gather at their Jackson Hole, Wyo. symposium Aug. 26. A more formal announcement that the bond buying program will be wound down at a Fed meeting between September and December. The actual taper is expected to start later this year or early next year. "I think it's different from what we saw in 2013 and 2015 when the market sort of had a tantrum," Frederick said. He added the stock market has stayed fairly steady. "The market is finally of the mindset that we really do need tapering. We do need higher rates this time," Frederick said. "There is a greater concern about the potential for higher inflation than there is for higher rates." Bond yields also moved higher into this week's inflation data which showed another 5.4% year over year pace in consumer inflation. "I almost wonder if it's another sell the rumor, buy the news," Leuthold's Paulsen said. "I think a lot of the market place, investors have come to grips that taper is going to happen this year. The bigger issue is when do short rates begin to rise. At this rate, tapering is a foregone conclusion. It's past. We're over it. We still don't have a lot of clarity on where short rates are going." Slowing the bond purchases would be the first step toward removing easy policies put in place during the pandemic. Once the Fed succeeds in tapering its program, the door is open for the central bank to move towards raising interest rates. Fed officials currently forecast two rate increases for 2023. The low rate environment has been credited with the high level of liquidity that has helped the stock market soar to lofty heights. Some investors worry these easy policies will allow inflation to run too hot or cause bubbles in markets. "I think more than anything the pressure is building on the Fed and quite frankly it's building on the Treasury of why are you continuing to do this in the face of data that any other recovery in post war history would have already brought a tightening," Paulsen said. He pointed to the hot inflation reports, including Thursday's higher-than-expected July producer price index. "Of late you not only have hot inflation reads...what's really changed is the real reports have gotten better again - ISM, jobs, claims - the real economic reports which kind of faded for awhile," Paulsen said. "I still think what the bond market is doing more than anything is sniffing out a peak in delta." Worries about the rapid spread of the delta variant of Covid had been holding yields down in recent weeks. 'Taper tantrum' Miller Tabak equity strategist Matt Maley said it can take the market a while but at some point it does react to policy changes or rate hikes. "When you have less liquidity, less stimulus sloshing around the system, it will have an effect on the system," he said. When former Fed Chairman Ben Bernanke set off the taper tantrum= in 2013, the reaction was swift. Goldman Sachs notes there was a quick 40 basis points [0.4 percentage point] move in rates and a 5% decline in stocks over five days. "The S & P 500 rebounded by 5% in the roughly two months following the tantrum, led higher by the Materials, Consumer Discretionary, and Health Care sectors," Goldman equity strategists wrote in a recent note. "Volatility declined dramatically and, by December, the S & P 500 had posted a full-year return of 32%. As the Fed reiterated its commitment to accommodative policy, Growth outperformed Value and cyclical stocks outperformed defensives." JPMorgan chief global markets strategist Marko Kolanovic said he believes that both yields and cyclicals bottomed, and both could move higher for the rest of the year. "While we believe bond yields will increase significantly, the risk of a broad market sell-off driven by tech-bond correlation is not high and can be mitigated. This is another reason why we prefer cyclicals, international stocks and value," the strategist wrote.

A trader works on the floor at the New York Stock Exchange (NYSE), August 4, 2021.

Andrew Kelly | Reuters