The April jobs report on May 3rd sparked a renewal of something I’m calling the "Taper Trade." As I mentioned last week, the effect of renewed faith in U.S. cyclical stocks post-Q2 earnings, along with a rise in the ECRI’s leading economic indicator, better housing data, and the jobs data has been a shift in investor sentiment back towards growth, and away from defensive tactical weightings in Treasuries, the dollar, healthcare, and utilities.
Three weeks ago, Federal Open Market Committee members offered speeches and interviews to lay out the timeline for a change to bond purchases, which would be postponed until the second half of the year. Now that the jobs data and other leading economic data are recovering, sentiment is beginning to shift again towards growth, and the likelihood of quantitative easing (QE) tapering if we have more than two consecutive months of strong job growth has increased. You see, the 165,000 jobs (modeled) in April were strong, but not too strong. Once we start seeing growth of 250k or more, the Fed will likely begin to taper its purchases. Too little, and investors perceive stagnant growth, resulting in deflationary fears. No, 165k was just perfect for the stock market.
The Fed’s latest policy decision (May 1) concerning bond purchases announced:
“The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes. In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.”
They made it very clear that they’re data-dependent, but the statement also made it evident that they’re willing to slow down QE as soon as possible. As such, we got the Taper Trade on May 3rd. Here are the simple attributes of the Taper Trade:
- Slow Growth approaching stronger growth
- Pro-Stocks
- Increasing probability Fed will taper purchases
- Less demand for U.S. Treasuries
- U.S. dollar strengthens as monetary accommodation shifts
- Commodities weaken
Lower inflation, a prolonged period of QE, and a drop in commodity prices will have a stimulative effect on sentiment, confidence, and discretionary spending, not to mention the fact that housing prices continue to rise, and sales have been strengthening. Many homebuilding stocks and construction material stocks are trading at fresh 52-week highs this month, and there’s plenty of room for the bull market in housing (see my housing article in March). The wealth effect continues to boost consumption; just take a look at some of the more notable charts, for Nordstrom (JWN), Ralph Lauren (RL), and Dillard’s (DDS).
In addition to the recent Jon Hilsenrath article posted last Friday, “Fed Maps Exit From Stimulus”, which discussed that the Fed has a plan to wind down its billion-a-month bond purchase program, the ECB has been teasing the market with “willing to do more” conversations from Mario Draghi and other ECB members. This weakens the euro, and strengthens the U.S. dollar, as currency traders anticipate a move by the ECB to weaken its currency. Eventually, I believe economic conditions will reverse for Europe, as headwinds fade from fiscal austerity, financial stress, and lower commodity prices help Europe exit their recession in the second half of the year. That will eventually strengthen the euro; but, for now, look for the euro currency to weaken, and the dollar to continue to strengthen based on stronger economics and a Fed considering an exit strategy for QE3.
If the euro breaks 1.28, a test of 1.22 is likely in the cards this summer, and that would be bullish for the dollar index and bearish for commodities.
Conclusion
The only catalyst out there worrying investors is anticipation of the point at which the Fed is going to start to remove accommodation, followed by the effects it would have on risk assets. Gold is languishing in this environment, despite the incredible central bank accommodation worldwide. Eventually, supply constraints and inflation will creep up when economic growth accelerates, but only if fiscal policy halts the austerity measures that continue to act as headwinds, such as spending cuts and higher taxes. Should the government continue this path, it will eventually result in a recession down the road. So far, the economy is weathering the recent changes with tepid growth that encourages the Federal Reserve to remain accommodative.
Don’t fear the Fed long-term. If fiscal policy can shift from restricting the economy, and growth is allowed to accelerate with the incredible amount of stimulus in the pipe, then we could see the economy grow even as the Fed removes accommodation, as has happened in the past. Rates rose from 1% to 5%+ from 2004 to 2007, as the S&P rose from 850 to approximately 1500. Stocks and monetary policy restriction can occur at the same time, as long as the economy is improving. Eventually, the Fed wins, and stocks roll over, but that wouldn't be for a very long time at this rate.
