Are Investors Ready for Fed to Back Off?

So if the economy is humming along as well as everybody says and the stock market is poised for double-digit gains in 2011, that must mean that the Fed can start planning its multi-trillion-dollar exit strategy.



Well, maybe not quite.

Though strategists in recent days have been progressively one-upping each other on economic and stock market projections for the year ahead, investors aren't quite ready to cut the cord to the massive easing policies that spurred the 21-month stock market rally.

"Investors absolutely are not psychologically ready for the Fed to start tightening," said Ward McCarthy, chief economist at Jefferies in Boston, adding that high unemployment in particular and fear that the economy remains unstable will keep investors tethered to Fed policies for months and perhaps years to come.

"Investors are taking their cues from the return of momentum to economic activity and also from the fact that what the Fed is trying to do is reflate the economy," McCarthy said. "If they're successful, that will create a higher inflation trajectory, which is somewhat hostile to the bond market and is why Treasury rates have risen. But it is also very beneficial for a variety of risk assets, including equities."

The capital market environment has found itself in an odd state since Nov. 3, when the Fed announced the second round of its stimulative quantitative easing program that will entail buying $600 billion worth of Treasurys.

Though the idea of QE2 was to drive down rates, they've actually risen to six-month highs, just as they did during the first round. Theoretically the US dollar should have fallen, but it too has shown a post-QE2 gain of 4 percentagainst a basket of foreign currencies. Stocks, coincidentally, also have gained 4 percent, an unusual occurrence considering the market has generally shown an inverse reaction to dollar activity during the recovery off the March 2009 lows.

Most economists have chosen to take the optimistic viewthat rates have risen due to increased confidence in the economy. But with unemployment jumping to 9.8 percent in November and the housing market teetering on the brink of a double-dip, there are some holes in that theory.

"How can anybody claim that this rise in rates is some kind of rebound in economic growth?" said Michael Pento, senior economist at Euro Pacific Capital in New York. "It's because of inflation, because of a massive amount of Treasury debt. There was no watershed event that occurred in the last few weeks that made everybody have an epiphany that the economy was improving."

Rather, Pento said, there are three forces that have impelled rates higher: a record November federal budget deficit of $150.4 billion, a failure of the president's debt commission to get congressional approval for its recommendations; and the jump higher in the jobless rate.

As such, investors are unlikely any time soon to be able to stomach the Fed cutting its programs aimed at injecting liquidity into the system. The central bank's balance sheet is at $2.3 trillion and growing.

"They are still light years away from draining liquidity," Pento said. "You cannot drain liquidity at the same time you're expanding the balance sheet."

That may be all well and good in the short term.

Most of the major banks are predicting 2011 gains for the Standard & Poor's 500 ranging from just north of 1,400—a 13 percent gain from Monday's close—up to Deutsche Bank's 1,550 target, which would be a whopping 25 percent surge.

But there could be a price to pay should the Fed find that the market is addicted to low rates while inflation is off to the races. The producer price index posted a stronger-than-expected 0.8 percent risein November, indicating that while inflation may not be in full gear, it certainly is revving the engine.

"People are hoping for inflation to be reignited and the Fed to retain control," said Brian LaRose, technical analyst at United-ICAP in New York. "It's going to be a very big mess when the markets realize the Fed is not in control at all."

In the meantime, investors seem content to let the Fed be the guide. In a statement from the Federal Open Market Committee after Tuesday's meeting, the central bank indicated no plans to back off QE or to raise rates, which are near zero.

"Investors would like to hear the Fed communicate more about an exit strategy," said Jeff Kleintop, chief market strategist at LPL Financial in Boston. "They have some concerns that the Fed might be fueling a bubble and would like to hear the Fed is focused on the other side of the equation."

But when that exit actually comes isn't likely to be until investors get more confidence about the economy.

The Fed's statementrepeated almost to the word the same language it has used since the downturn began, with significant reservations about the direction of the economy, despite the bullish projections.

"If we start seeing leading indicators move up and we see unemployment coming down, the market will be prepared to see the end of this tranche of quantitative easing," said Quincy Krosby, general strategist at Prudential Financial in Newark, N.J. "But let's just remember that when quantitative easing ended and all the stimulus ended in April, we saw the market suffer."