Inconsistently consistent: too much focus on the “taper”

Interest sensitive equities got spanked yesterday as a “good” growth report shook the equity and bond markets again. Another example of good news becoming bad news for investors and renewing an already enlarged focus on what the Fed will do the next time the FOMC meets. Markets have become inconsistent with common sense but in that inconsistency, there are guided by a Fed that is “inconsistently consistent.”

Today’s Employment Report is another data point in the sequence of good news is bad news. In the same vein, bad news has frequently become good news in the long run-up of equity prices and the upward tilt since April/May in the 10-year bond rate. Equity and bond investors are hung up on whether the Fed will continue to “juice” the market with $85 Billion in monthly quantitative easing. When Bernanke spoke in May, markets seemed to interpret his carefully hedged statements to indicate that the Fed would soon begin reducing its acquisition of treasuries and mortgage paper. Then, the economic news seemed to indicate a softening or at least a pause. Subsequent FOMC meetings reflected continuing amounts of QE. September and October meetings had the same inconsistent consistency with the Fed emphasizing its data dependence, its focus on bringing down the unemployment rate and its (only slightly concealed) concerns that the inflation rate was too low! Markets liked continued QE, but yesterday, with a seemingly “good” 2.8 % growth rate in QIII2013, equity markets had an interrupt. The market fell some 1.3% (S&P 500 index off 23.34) for its largest loss in the last two months, and the ten-year Treasury was up 11.5 basis points (5.4%) to 2.716.

As we write this market seemed to have some stability (contrary to what some market Seers would have projected) from a better than expected Employment Report. But the day is not over. There appears to have been a 212,000-job gain in the private sector (204,000 counting the government) despite a rise in the Unemployment Rate to 7.3%. The later perversity reflects Household data showing drops in the labor force being smaller than the drops in employment. Bottom Line: High frequency data such as we get each month are often very poor predictors of the next month’s results. Smoothing out each series over a 3-6 month period often provides a better characterization of where the economy has been. Unfortunately, even smooth trends don’t really tell a Central Bank what is likely over the next 3-6 months. This should underscore the peril of a “data-dependent” Fed trying to make monetary policy into a short run medication for economic instability. A steady, unshaken hand on the monetary tiller is not what Washington savants want, even if you get them to admit that Fed forecasting is never much good.

For investors who think that Macro will help them time their purchases and sales of individual stocks or even of indices, the important lesson is that market timing doesn’t pay very good results. First, you have to predict what the economy would do under the current prescribed policy matrix and then you have to predict the inconsistently consistent Fed…and if that were not enough, you have to enter the realm of the fabled Keynesian “beauty contest,” in which you are asked what will the others pick as the most beautiful, not what you think is the raging beauty. A mug’s game to say the least.

What about the Fed? What will it do for the rest of the year? Here’s our prediction, but we warn you not to translate it into your equity and bond choices! We think the Fed continues its current policies and does not taper this year! We base our reasoning on how the current Fed sees potential gain or loss from a change in their QE policy at this moment.

They are surely looking at markets to give them guidance and they will infer that a “taper” will push down asset prices and raise bond yields in the short run. With no inflation on the horizon, the costs to employment via reduced expectations of future growth by business and households, could be negative…And the Fed is now a political body, no matter what it says!

To start a tapering action this year, before the new Fed Chairwoman takes office could place next year’s FOMC into another “reversal” position. No matter if Yellen is a Dove as most commentators allege, if business and consumer expectations turn a bit sour with a November/December back off from QE, employment would likely suffer. The risk to the upside (higher inflation at some unknown time in the future) is almost certainly to be seen as moderate at worst by this Fed. Hence, we conclude that the current FOMC is not likely to start tapering with an impending change in leadership just around the corner. If employment and output growth continue to be firmer throughout November and December, a January or February shift in monetary policy would seem much more likely.

If the foregoing forecast seems to reflect a kind of “consistency,” remember that over the past several years, it has become increasingly difficult to discern which of the two mandates is more important to the Fed. This past year, it would be hard to argue that anything other then employment is top dog. This Fed is fearful of tightening too soon and it has a long series of very moderate inflation indicators upon which to rest its case. Where it to tighten in November or December, it would be forcing a potential reversal upon the incoming Chairwoman read the economic tea leaves differently or thought that there still was too much slack in the economy. Failing to taper in September—a move that fooled market players—has hooked the Fed into a long pause, despite the rancor of Fed hawks. But the Doves still rule the roost and tying the hands of an incoming Chairwoman is an unlikely outcome in our view. Just chalk up another $170 Billion on a very fattened Fed balance sheet. It will be hardly noticed!