Markets May Be Overpricing Risk of Fed Tapering

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Financial markets remain on edge as investors worry about the Federal Reserve pulling back on its bond purchases and what it will mean for stocks and bonds. Wild gyrations in overseas markets like Japan only have added to the volatility in recent weeks.

But Fed tapering fears may be overdone at this point, say strategists, given the U.S. employment and inflation pictures.

Since the 2013 low in Treasury rates on May 3, markets have begun to expect a sooner end to easy Fed monetary policy due in large part to strong April payrolls data and dovish Fed members suggesting stronger economic data could lead to a tapering of asset purchases as soon as September, according to a presentation by ING Investment Management.

But while some are expecting the Fed to start withdrawing stimulus as early as this fall, ING anticipates the Fed will continue its asset purchases until mid-2014.

Christine Hurtsellers, ING Investment Management's chief investment officer for fixed income, said at a press briefing that U.S. Treasurys and other markets have "overpriced" the risk of Fed tapering.

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"What the market continues to miss," Hurtsellers said, "is that the Fed has two targets—inflation and unemployment." And she notes that global inflation is in decline, which makes it harder for the Fed to ease up on bond purchases even as the labor market shows signs of modest improvement.

Other strategists agree that the market's taper fears are overdone. "The Fed is going to be in my opinion very reluctant to take the foot off the accelerator unless we see the dramatic improvements in the employment market—and we didn't see it Friday—or if we see a dramatic uptick in inflation," Steve Massocca of Wedbush Securities told CNBC. "We have seen the exact opposite and inflation numbers coming in better pretty much worldwide."

ING believes the risk is that the Fed extends quantitative easing instead of ending it too soon. But with investors watching every bit of economic data closely for any clues as to when tapering may come, ING expects more volatility in markets around economic data releases.

While there's no major economic data on the calendar for Wednesday, weekly jobless claims, retail sales and business inventories are due out on Thursday. Markets also get a look at wholesale inflation data on Friday as well as consumer sentiment and industrial production.

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Even if the Fed begins to taper earlier than some are forecasting, a gradual pullback shouldn't upend markets.

"We don't understand why the Fed buying $65 billion or $75 billion worth of bonds is a reason to freak out either on the rate side of things or the equity side of things," BTIG's Dan Greenhaus said.

"I'm not saying there shouldn't be a correction as equities begin to price in higher interest rates but the idea that the entire thing, the entire recovery, the entire equity rally is built on some falsehood that's going to fall apart at the faintest sign of higher interest rates is something I disagree with," he added.

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Greenhaus added that what's needed for higher stock prices is an improving economy and growing corporate profits and profit margins, not central bank accommodation.

ING's Hurtsellers sees opportunity to take advantage of the overreaction to potential Fed tapering to get into areas of the fixed income market like high-yield corporate bonds.

"If you can get high yield at 6 percent," ING's CIO of the multi-asset strategies group, Paul Zemsky, said, "versus a 7 percent or 8 percent expected return in equities, you take notice."

He also sees opportunities in equities, but warns that the safer the sectors, the more expensive it is. "The more certain the cash flows, the more overvalued the sector," he cautioned.

Zemsky likes U.S. equities, trading on 14 times 2014 earnings, over emerging market stocks, value over growth and sees industrials as one sector that could benefit from a better U.S. economy.

By CNBC's Justin Menza. Follow him on Twitter @JustinMenza.