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Expect a Gradual Fed Tapering

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Written by: Russ Koesterich | September 16, 2013 | Topics: Economic Outlook, Equities, Fixed Income

Overview

·        The Fed will likely announce only a modest reduction in the rate of its asset purchases.

·        A lack of inflation and a shaky economic recovery should provide the Fed with flexibility to move slowly as it shifts policy direction.

·        An environment of more steady interest rates should provide support for high yield bonds and emerging markets equities.

Stocks Rise in Advance of Fed Meeting

All eyes are on the Federal Reserve’s policy meeting set for Tuesday and Wednesday of this week as investors are expecting the long-awaited announcement of a reduction (or “tapering”) of the Fed’s asset-purchase program. At this point, expectations appear to be that tapering will be slower and less dramatic than had been telegraphed a few months ago. That shift in expectations, along with some easing of tensions on the geopolitical front, helped stocks to a strong rally last week. For the week, the Dow Jones Industrial Average rose 3.0% to 15,376, the S&P 500 Index climbed 2.0% to 1,687 and the Nasdaq Composite advanced 1.7% to 3,722. Fixed income markets were relatively muted last week. The yield on the 10-year Treasury declined modestly, dropping from 2.94% to 2.89% (yields move inversely to prices).

More Volatility (and Opportunity) Ahead

While volatility is likely to remain elevated going into the fall, Russ Koesterich explains why it’s important to put current volatility in the context of historical standards and highlights how investors can use it as an opportunity.

Look for “Tapering Lite”

After months of waiting, investors should finally get some clarity on the issue they have been obsessing over for months: the future path of monetary policy. Our view is that given the softness in the economic data and the lack of inflationary pressures outside of oil prices, the Fed will announce only a modest reduction in the rate of their asset purchase program. Specifically, we expect the Fed will reduce the size of their monthly asset purchases from its current level of $85 billion to somewhere between $70 and $75 billion. Additionally, since this sort of reduction appears to already be priced into the markets, we think that long-term interest rates should be relatively contained over the coming months.

So why won’t the Fed announce a larger reduction? First, because it doesn’t have to. The Fed has a great deal of flexibility to move slowly since inflationary pressures are almost nonexistent. Last week’s release of August’s producer price inflation data helped confirm this benign environment. Producer prices were up only a modest 1.4% on a year-over-year basis, and without the more volatile food and energy components, prices rose only 1.1%, the lowest level since the summer of 2010.

At the same time, the economic recovery remains shaky. As we’ve been highlighting recently, job growth has not accelerated and wages and consumption remain soft. Moreover, the housing market has grown as a source of concern, given the tight relationship between interest rates and housing. With interest rates rising over the past few months, mortgage rates have been climbing. This situation has already had a negative impact on housing activity and has severely curtailed refinancing. The Fed will be wary about taking any action that could put the housing recovery in jeopardy and does not want to see a steep backup in yields.

High Yield Bonds and Emerging Markets Equities Should Benefit

What, then, are the investment implications of a taper lite? We do think that near-term financial market volatility will remain relatively elevatedas investors scrutinize the details of the Fed’s coming announcement. In particular, there will be a great deal of focus around the question of when the Fed intends to actually increase short-term rates, which we continue to believe won’t happen for some time. As we indicated earlier, however, expectations for a taper lite appear to be reflected in the markets, meaning that absent stronger economic data, interest rates are likely to remain range-bound for the coming months.

A more stable interest rate environment should translate into better performance for emerging markets equities, a trend that we have already started to see in recent weeks.


Such a backdrop does present some near-term opportunities. High yield bonds should benefit from an environment of stable rates and a slowly improving economy. Another asset class to consider would be emerging markets equities. This area of the market has been punished in recent quarters as higher interest rates and a stronger US dollar have been putting pressure on many emerging markets currencies. A more stable interest rate environment should translate into better performance for emerging markets equities, a trend that we have already started to see in recent weeks.


This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of September 16, 2013, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

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Prepared by BlackRock Investments, LLC, member FINRA.
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