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Dispelling Myths About Fed Tapering 

Kristina Hooper 

The Upshot 

8/19/2013 

The markets continue to have a negative response to stronger employment data as jitters about an unwinding of QE take root. But the feared outcomes may be based more on fiction than fact, writes Kristina Hooper.
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Kristina Hooper, CFP, CAIA, CIMA, ChFC, is US head of investment and client strategies for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.

Investors are having a tough time digesting the pending Fed taper. But perhaps it’s because there are misconceptions about what actually will happen.

We’ve seen some nasty selloffs when the likelihood of paring asset purchases becomes more palpable. It’s a pattern that keeps repeating itself. Last week, stocks experienced a substantial drop while the yield on the 10-year Treasury rose significantly. Investors were responding to positive economic news, primarily initial jobless claims, which heightened fears that the Federal Reserve will begin tapering in September.

Taper Creep Chart


As Yogi Berra would say, this is “déjà vu all over again.” Back in late May, the markets were jolted by indications from the Fed that tapering would happen sooner than originally anticipated. Investors reacted by selling stocks and bonds. We saw a similar scenario last week with the release of first-time claims for unemployment insurance. Since the Fed is so laser-focused on employment, the data took on far more significance and caused many investors to believe tapering is drawing near.

One would think that investors have gotten used to the idea that the Fed might taper as early as September and yet it was as if this was the first time they had ever heard the idea. But investors need to get over their fears because tapering is inevitable. A few thoughts to help keep things in perspective:

1
Expect the unexpected.
Even if the taper begins in September, it might be insignificant. As I wrote several weeks ago, there is the possibility that the Fed starts small, with a “tiny taper.” St. Louis Fed President James Bullard said, “A larger move would be interpreted as a faster pace of reduction. A smaller move would be considered a more hedged bet, a slower rate of reduction in purchases." The taper could also be initially limited to government bonds, while the Fed continues to purchase the same amount of mortgage-backed securities. This could help maintain a housing recovery, which is crucial for a healthy consumer.
2
It’s a confidence game.
When the Fed decides to taper, it will most likely do so because it’s confident the economic recovery has legs. Most yield curve measures—2s vs.10s, 2s vs.30s and 2s vs.5s—are all at, or close to, their steepest levels in two years. This indicates the market is implicitly pricing in a strong acceleration in growth, and suggests confidence in the Fed. In a May speech, New York Fed President William Dudley explained that one of the flaws in Japan’s monetary policy in the 1990’s was that it ended QE too quickly, preventing it from supporting a sustained economic recovery. That’s a lesson that has not been lost on many members of the FOMC. We think the Fed will ensure that rates remain “behind the curve” of economic growth, continuing to help support the recovery.
3
The Fed’s not trimming its balance sheet.
Even with tapering, the Fed is still expanding its balance sheet in net terms, and it has no plans to reduce the portfolio of bond securities it currently holds on its balance sheet.
4
The jobless rate target could move.
The Fed could revise the 6.5% unemployment target if it happens too quickly and it’s not reflecting underlying improvement in the economy.
5
Inflation remains tame.
Recent data suggest that inflation is not an issue, at least in the near term, despite the aggressive monetary policy we’ve seen in the United States in the past few years. That gives the Fed more room to maneuver.
The bottom line: Investors need to get comfortable with the idea that the Fed is going to taper. We’ve had some time to digest it. And it’s going to happen eventually. But it’s also important to understand that monetary policy will remain accommodative and supportive of risk assets.


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The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

 
Past performance of the markets is no guarantee of future results. This is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities.


A Word About Risk
: Equities have tended to be volatile, involve risk to principal and, unlike bonds, do not offer a fixed rate of return. Foreign markets may be more volatile, less liquid, less transparent and subject to less oversight, and values may fluctuate with currency exchange rates; these risks may be greater in emerging markets.
 

Allianz Global Investors Distributors LLC, 1633 Broadway, New York NY, 10019-7585, us.allianzgi.com, 1-800-926-4456.

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