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Michael Farr Headshot

Taper and Tantrums

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The Federal Reserve Open Market committee met Tuesday and Wednesday for its regular September meeting in Washington. The Committee's decision was released at 2:00 p.m. Wednesday. The Fed announced that it will make no change to its QE program, which calls for ongoing monthly purchases of $85 billion in Treasury bonds and mortgage-backed securities (MBS). The markets were caught by surprise.

Markets rallied on the news, with the Dow Jones Industrial Average gaining over 150 points at the time of writing. The bond market, which was down before the announcement (with yields higher), reversed course dramatically. The yield on the 10-year Treasury now stands at 2.69 percent compared to 2.87 percent prior to the announcement. This is a huge move in the bond market. Gold is up over 3 percent as the promise of continued Fed support sent the gold shorts scrambling for cover.

Chairman Bernanke gave the following reasons for the decision to maintain the current monetary course: 1) the committee wants to be sure that the recent progress we have seen in the labor market is sustainable; 2) the committee wants to ensure that inflation continues to rise closer to its target 2 percent following a recent dip; 3) the committee wants to ensure that a recent tightening in financial conditions (read: increase in interest rates) will not constrain the progress that's been made; and 4) continued uncertainty surrounding fiscal policy poses risks to the economy.

While we had suspected the Fed might forego the taper due to the fact that its own conditions for doing so had not been met (see our recent Market Commentary on August 14 entitled "NO TAPER in September"), we do not necessarily believe this is a positive development for the longer-term health of the economy and markets. Markets can process and react to good news or bad news, but they hate uncertainty. We view the continued uncertainty over tapering as a potential negative. A stock market fueled solely by the promise of continued easy money is not a healthy stock market, in our view.

The chart below shows the S&P 500's performance before, during, and after periods of Fed intervention. It is abundantly clear why a transparent plan for tapering is crucial. The Fed kicked the can down the road today because it is worried about the sustainability of recent economic progress in the face of a sharp rise in interest rates (their terminology is a "tightening in financial conditions"). While this can certainly be justified, the band-aid will have to come off at some point. The unwillingness to begin this process says a lot about the Fed's confidence (or lack thereof) in the strength of the recovery.

Along with this important news, the fiscal side of government is waging a war of words of its own. The "Continuing Resolution", which has provided the current funding for the US Government, expires on September 30th. Washington is racing toward yet another debt limit. At the Economic Club of Washington's breakfast on Tuesday, Treasury Secretary Jack Lew said a rejection of a debt ceiling hike could jeopardize government payment of Social Security checks and salaries for U.S. troops. Obviously it raises the political ante when you start to talk about retirees and servicemen and women.

On the other side of the aisle, House Speaker John Boehner said the House will pass a bill to keep the Government funded that will take money from the Affordable Care Act. Boehner said that the GOP very much wants to disable the Affordable Care Act, which they see as bad policy. He also pledged that Republicans do not want to shut down the government. The president, for his part, spoke Wednesday and called the Republicans' strategy, "the primary roadblock to resolving the budget." In the world of Washington politics, both sides have drawn bright red lines that will be difficult to cross or take-back. It's becoming abundantly clear that a showdown is brewing.

Investors have been through any number of tough and turbulent times over the past few years. From January's tax increases to Syria, the list has been mind-numbing. Our investment approach continues to be defensive and deliberate. Stocks that appear fully valued continue higher. (Please see last week's commentary: "Ready for A Pullback?") Shares of large multi-national companies with solid balance sheets, strong cash-flow and steady earnings growth make most sense to us. In time this noise will fade. Remember that the best advice in the fish market is to ignore the screaming and yelling, and pay attention to the price of fish!

Peace,

Michael