By Ryan Vlastelica
NEW YORK, Sept 13 Months of anticipation will
come to an end next week when the Federal Reserve finally says
whether it will start to rein in its massive stimulus of the
economy, which has flooded financial markets with some $2.75
trillion over the past five years, supercharging returns on
everything from stocks to junk bonds.
But for all the concerns that the reduced presence of such a
giant asset buyer would be calamitous for investors, it appears
equity and bond markets are poised to take next week's Fed
decision largely in stride - provided the central bank doesn't
surprise with the size of its move or shock in some other way.
The Fed has telegraphed its intentions to pare back its
monthly purchases of $85 billion in bonds at its two-day meeting
that ends next Wednesday. The scale of the tapering and what Fed
Chairman Ben Bernanke might say at his press conference are key
here, but the steady messaging in the last few months means next
week probably won't see carnage in the markets.
Investors have already done a lot of work in absorbing the
Fed's message. Benchmark bond yields are now hovering near
two-year highs, while stocks have edged off highs reached in
early August, removing some of the froth that had started to
concern some investment strategists.
"The Fed already got tapering without actually tapering,"
said Daniel Heckman, senior fixed income strategist at U.S. Bank
Wealth Management in Kansas City, Missouri.
Key measures of volatility and futures positioning show
there is not much fear. The CBOE Volatility Index, the
market's favored gauge of Wall Street's anxiety, hovered around
14 on Friday, a level associated with calm markets.
The Fed has said it would wind down its program if it is
confident that the economy is improving, particularly that the
jobless rate is heading lower. If it delays any action, it could
raise concerns that it fears economic growth is going to be too
anemic without the Fed's help.
Recent data has been mixed, with August jobs and retail
sales data falling short of expectations. Consumer sentiment has
fallen in part due to rising interest rates.
That's prompted analysts to issue only modest forecasts for
the reduced buying. A Reuters poll showed a consensus for the
program's $85 billion monthly pace to be cut by $10 billion,
less than earlier estimates.
However, the current low volatility means the Fed runs the
risk of spooking markets if it moves too quickly or surprises
with its intentions.
"The Fed needs to move from being aggressively stimulative
to merely very stimulative," said Leo Grohowski, chief
investment officer at BNY Mellon Wealth Management in New York.
"Markets are less prepared for it to do more, and if it does you
might see a return to defensive areas."
In May, after Bernanke spoke about potentially slowing
stimulus this year, the S&P 500 fell 7.5 percent. The
index is unlikely to see a similar decline on any surprise next
week, with many analysts citing its 50-day moving average as
support. Currently, the index is 0.7 percent above that level.
Still, investors have been taking steps to reduce risks
ahead of such an important announcement. Trading in options of
the S&P 500 tracking exchange traded fund - the SPDRs -
was dominated by bearish put buying. Put contracts give a holder
a right to sell a security by a given date at a certain price,
and are generally used to hedge against declines.
A total of 1.16 million puts and 559,000 calls changed hands
in the SPY fund on Thursday, a ratio of 2.08 to 1, according to
options analytics firm Trade Alert. That ratio is above the
22-day moving average of 1.64.
"As we head into the weekend and the Fed meeting next week,
traders are starting to hedge their long equity positions," said
JJ Kinahan, chief strategist at TD Ameritrade.
Michael Mullaney, who oversees $10.7 billion as chief
investment officer at Fiduciary Trust Co in Boston, said his
firm was pulling back because of the uncertainty.
"We don't want to get aggressive for a while; there are just
too many uncertainties to get through before we add more risk,"
he said, also citing seasonal issues and government budget
policy as overhangs.
That sentiment prevailed among many investors in August,
resulting in a 3.1 percent loss for the S&P that month, the
worst monthly performance in a year. That decline helped
restrain S&P valuations, with the forward price-to-earnings
ratio of the S&P 500 currently at 14.6, according to Thomson
Reuters data, in line with a historic average of 15.
Sectors tied to the pace of economic growth have been among
the biggest beneficiaries to the Fed's policy, with both the
financial and consumer discretionary groups up
more than 20 percent this year, outpacing the S&P 500's
18-percent rise. Any surprise from the Fed could hit those
groups the hardest.
"Those economically sensitive groups would pullback the
most, and housing is at the top of any list of vulnerable
sectors," said BNY's Grohowski, who oversees about $175 billion
in client assets.
Housing stocks have performed well recently, rising
6.3 percent in September, but remain more than 16 percent below
a peak reached in May. The sector could weaken further if the
Fed takes any steps that lead to a rise in interest rates.
"Both stocks and bonds will like it if the Fed tapers $10
billion only in Treasuries. If it pares down on its
mortgage-backed security purchases, we're very worried about
what that will do to the housing market," said Mullaney.
The Fed is expected to maintain its current level of
purchases of mortgage securities, focusing instead on pulling
back on its $45 billion in monthly buys of Treasury notes.
Anticipation of this has pushed yields on the 10-year Treasury
note higher for five straight months.
Still, blistering demand for Verizon's record $49
billion bond deal this week, together with a solid reception for
the government's $65 billion in debt supply this week, signaled
investors might have grown less wary of reduced stimulus.
HURTING EMERGING MARKETS
In the currency market, an aggressive Fed could lift the
U.S. dollar "by pushing rates up at the long end, making U.S.
yields more attractive, and at the short end as well, making
Japanese investors, among others, worry that hedging costs could
go up quicker than expected," said Steven Englander, head of
currency strategy at CitiFX, a division of Citigroup, in New
Emerging markets were hardest-hit once the Fed started to
lean in the direction of cutting stimulus, with sharp selloffs
in debt and equity markets around the world. Some markets have
since recovered some losses, but investors have been hedging
against any Fed shock that could hit those markets.
Mike Tosaw, financial advisor at RCM Financial Services, an
investor advisor in Chicago, said his firm has a put position on
the iShares China Large-Cap ETF.
"Now is definitely not the time to take it off because what
happens with the FOMC meeting next week could have a ripple
effect on global markets," Tosaw said.
While the Fed will be the primary market driver next week,
investors will also look to quarterly results from FedEx Corp
, viewed as a proxy for economic activity, and software
giant Oracle Corp. The market will also see data on
August housing starts and existing home sales, and the monthly
Philadelphia Fed business index.