All Eyes on Fed

Terry Flanagan

All eyes will be on Wednesday’s Fed meeting, with the question of tapering looming at the start of the week. While economic indicators have been decidedly upbeat over the past several weeks and last week’s surprise budget deal in the House clearly increases the chance of tapering, tapering after the January or March meetings is far more likely due to several factors.

“The big question for Wednesday is will they or won’t they – taper, that is,” said Randy Frederick, managing director of active trading and derivatives at the Schwab Center for Financial Research. “I still believe January or March are more likely, but the round of profit taking point to growing concerns. Traders should expect lots of volatility and uncertainty as this announcement approaches.”

Frederick noted that Janet Yellen is set to take the helm of the Fed at the beginning of February, and as a result tapering is unlikely to begin prior to the start of her term. Also, core inflation by any manner of calculation is still running well below the Fed’s target of 2.0%.

“Although the budget deal mostly resolves government funding and sequester concerns in the near term, it does not include a resolution on the debt ceiling – which is only good through Feb. 7,” Frederick said. “The debt ceiling debate has historically caused far more market anxiety than any government shutdown.”

Bonds will continue to underperform as longer term interest rates rise due to stronger economic growth, which will prompt the Federal Reserve to end its program of quantitative easing, according to Scott Wallace, founder and chief investment officer at Shorepath Capital Management.

“How high could interest rates go during 2014? We believe the next several years will represent a renormalization of interest rates to levels dictated by economic fundamentals rather than central bank policy,” he said. “The best long term estimate for the yield on the 10 year treasury is the level of nominal GDP.”

During 2014, Wallace estimates nominal GDP will be in a range of 4.5 to 5%. Because this process of renormalization will take several years, 10 year treasury yields will rise only part of the way to their longer term equilibrium level.

“As a result, we see 10 year yields ending 2014 between 3.5 and 3.75% and overall fixed income total returns of approximately zero to slightly negative,” said Wallace.

The week also brings some important economic indicators, with unemployment and housing numbers due out Thursday. “There is little consensus whether good news is good or bad right now, with the indicators that I watch showing everything from fully bearish to fully bullish,” Frederick said.

Last week, jobless claims jumped sharply by 68,000 to 368,000. “While this is the biggest jump since the California reporting problems back in early October, the consensus perspective seems to be that it was mostly due to seasonal adjustments,” Frederick said. “With this much uncertainty about the adjustments, it’s nearly impossible to guess what to expect on Thursday.”

Thursday also brings the existing home sales report for November, which is a good measure of overall demand in the housing market. “For the past two months, the numbers have come in below target and the SPX did not react favorably,” Frederick said. “Since this report often reflects the NAHB Housing Index report which is due out on Tuesday, traders can look to that report to set the trend.”

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