On the other hand, what if the committee members vote in favor of waiting a few more months? What if they collectively decide that the economy is not genuinely strong enough for tapering just yet? What if Chairman Bernanke prefers to let a significant policy change be made by the incoming chairman, not himself? If tapering is put on hold entirely, the Fed would effectively be inflating a housing bubble some more, sending the 10-year Treasury yield plummeting back toward the 2.6% to 2.5% level. If the Fed were to essentially insinuate that job data or the economy were not strong enough for the removal of a very modest amount of emergency bond buying, one should also expect a wave of confusion for most U.S. stocks. The exchange-traded winners would be the interest-rate sensitive assets — SPDR Select Sector Utilities (XLU), iShares Mortgage REITs (REM), Vanguard REIT (VNQ), Homebuilders (XHB), iShares 20 Year Treasury (TLT), iShares Preferred (PFF), iShares 7-10 Year Treasury (IEF), etc.
Is it likely that the Fed will attempt to stand pat? It might be too difficult to achieve, considering how far the bond market has gotten out in front of the Federal Reserve. It is far more probable that they will taper by the smallest and most insignificant of amounts, hoping that bond yields refrain from climbing further while still bolstering stock market enthusiasm.
And then there’s the most unlikely scenario of all… but it is not beyond the realm of possibility. What if Fed Chairman Bernanke wants to make a more definitive statement prior to his exit? What if Bernanke sides with hawks who feel that “enough is enough” on the stimulus? What if instead of trying to keep longer-term rates below 3% by emphasizing the need for ultra-accommodating monetary policy, committee members exclaim that labor trends and economic trends are actually showing signs of accelerating? And what if Fed members see the long-term trend on declining housing affordability, worry about creating yet another bubble, and subsequently decide that significant tapering is needed to keep mortgage rates closer to 5% than 3.5%? Most investors would be deterred by “Large-Scale Taper” when most are expecting “Taper Lite.” A sell-off for broader U.S. stocks would be in the cards. Bond yields might also surge, creating price depreciation across the income spectrum as well. The exchange-traded winners would likely be short positions such as ProShares Short Dow 30 (DOG), ProShares Short S&P 500 (SH) as well as Ultra Short 7-10 Year Treasury (PST) and Ultra Short 20 Year Treasury (TBT).
Again, investors are likely to get what they are expecting here: a light peppering of taper around a meager 10% ($8.5 billion) of the $85 billion. Bonds might gain (yields decrease) on a “buy the rumor, sell the news” event. Stocks might rocket ahead at first, but they would likely come back down to earth with debt ceiling debates and earnings warnings on tap. Nevertheless, there are ETFs if the Fed goes against conventional wisdom, whether they encourage the “housing recovery” by shelving the tapering discussion, or whether they squelch speculative real estate altogether with an unusually large decrease in the amount of bonds that they purchase.
Gary Gordon is president of Pacific Park Financial, Inc.
