By Todd McNeill

The Federal Reserve’s announcement that it would begin curtailing its bond-buying stimulus program received a positive reception from the capital markets, but perhaps we should hold off on the celebrations.

The central bank stated that it would reduce its $85 billion in monthly purchases by $10 billion beginning in January 2014 while at the same time keeping its target policy rate at near-zero for an extended period of time. That decision was met with a surge in stock prices while bond yields have mostly risen at a modest pace.  The 10-Year Treasury just broke 3% during the week before Christmas.

Albert H. Teich /

Albert H. Teich /

Previous mentions by the Fed of tapering were not contemplated until the second quarter of 2014, and whenever the Fed did mention these dates, the debt market sold off sharply and stocks retracted.

Investor optimism surged over the past week to levels not seen since January 2011, according to a survey of members compiled by the American Association of Individual Investors. The boost indeed coincided with the Federal Reserve announcing last week that it would start tapering its monthly asset purchases.

For the week ending on December 26, bullish sentiment, or expectations that stock prices will rise over the next six months, jumped 7.6%. Over December, the Dow Jones Average climbed 2.3%, and the S&P 500 Index has gained 2% to reach all-time highs.

It appears that investors continue to be encouraged by the new record highs established by the large-cap indexes. The fact that Congress could finally agree on a two-year budget deal has also alleviated worries about another partial government shutdown occurring next year.

According to a recent interview with the PIMCO CEO, the Fed is not ready to do anything drastic, and there is still good reason to be cautious.

  • The Fed’s monetary policy is still artificially inflating asset prices, which means that assets may be over-priced compared to fundamental economic indicators like extension of credit and use of cash for economic investments. Until the economy improves enough to line up with asset prices, concerns will linger.
  • The central bank is due to lose some of its control when its switches from its direct monetary policy of buying bonds to its indirect mechanism of issuing forward guidance about the path of interest rates. That raises the question of how well the Fed can keep a lid on rates. One sign of that is the sharp move higher in the 5-year Treasury yield, a note that is heavily influenced by the path of monetary policy. The 5-year yield is up roughly 25 basis points since before the policy announcement.
  • Equities/Stocks have been red-hot recently, which could be “disruptive” if they reverse with the same force.
  • Other central banks besides the Fed have also been partaking in highly accommodative monetary policies. They will also have to contend with the tricky exit process.

Most believe that the Fed will hold its short-term interest rates near zero until 2016.  This seems like a predictable event as the government will have a hard time servicing the national debt if short-term interest rates rise even moderately.

In the meantime, retail sales in November grew at the fastest pace since June. Employment gains last month indicate that consumers should be larger contributors to economic growth in the near future.  The gain was unexpected but welcome after the National Retail Federation reported a 2.9% decrease in retail sales during the Thanksgiving shopping weekend.

Consumers are spending more despite an overall lack of confidence in the economy. In November the consumer confidence index retreated two points to 70.4, the lowest level since April, when sequestration commenced. The combination of healthy retail sales and low consumer confidence indicates that additional pent-up demand exists. As unemployment drops further in early 2014, we should expect retail sales growth to hasten.

All of this should provide great intrigue for the upcoming year of 2014 as the U.S. economy continues to get better from the lows we witnessed in 2009 and 2010.

Here is to a happy New Year for all from Metropolitan Capital Advisors!