S&P 500 and Tapering by the Federal Reserve

by George Hatjoullis

S&P 500 and tapering

The minutes of the July 30-31 FOMC meeting of the Federal Reserve (http://1.usa.gov/1au1wRX) are quite clear that tapering will begin this year. The only issue is exactly when and what else they might do in addition. The discussion suggested that the Fed may adjust forward guidance with regard to when it might raise the Federal Funds rate. Tapering may come with a lowering of the reference unemployment, presently 6.5%, at which they would consider raising rates, subject to inflation remaining subdued.

In may the revelation that tapering was on the horizon saw the S&P 500, and many other equity indices, correct sharply (see above chart courtesy of IG Index). The S&P 500 recovered after June 24 to make a new high. Talk of September tapering in recent weeks has brought the S&P 500 down to the support line at which the May-June correction halted. It is now on a support level and the question is will it hold?

Markets discount news and it is hard to argue that tapering event is not now fully discounted. The only uncertainty is precisely at which meeting it will take place but since it is almost certainly going to happen this year, this is of secondary significance. Moreover, the Fed have demonstrated that it is fully cognisant of market and economic risks arising from tapering and has indicated it might consider adjusting forward guidance on the Federal Funds rate. This is hardly a high risk monetary policy.

The tapering event is now so well flagged and understood that it is likely the equity market will embark on a rally after the event. Equity markets may trade nervously until the event, though further downside from here may be limited. The odds still favour an early move to tapering (18 September) with an adjustment of forward guidance perhaps. The Federal reserve is not unaware that having confirmed tapering is coming it would be best to get the start out-of-the-way.