How Did The Fed Catch Markets Off Guard? What Does it Mean for Investors?

The Fed’s decision on Wednesday caught the markets off guard – rather than begin tapering, as most expected, it held off, announcing it would stay the course. The market seemed thoroughly surprised, which is why the reaction was strong and aligned directionally across most markets – we saw U.S. Treasuries and equity markets rally, while the dollar weakened.

This reaction is ironic because the Fed has gone through a lot of trouble to reduce volatility through forward guidance, press conferences, etc., The Fed’s “body language” since May has suggested that they were going to taper and, had they done so, the markets probably would not have reacted much at all. I thought the Fed was in a good position to start their tapering in U.S. Treasuries because most of the economic data has been improving.

Yesterday there was a series of economic data released (existing home sales, leading indicators, Philadelphia Fed outlook) suggesting continued improvement in the U.S economy, notwithstanding the question marks around initial jobless claims. This is in contrast to the Fed’s uncertainty about the U.S. economy. The bond market accordingly saw a modest rise in yields.

How Should Investors React?
In our view, investors should stay focused on the economic data, maintain their investment thesis and ignore any of the “body language” from the Fed. Markets react to economic data. We saw that yesterday with a sell-off, in light of the strong data released. In May, Treasury rates had already begun to rise prior to the Fed’s comments. This was attributable at the time to the data that was showing an economy beginning to stabilize.

We cannot be certain, but if economic data continues to improve, as we anticipate it will, tapering will be back on the agenda before year-end. The Fed is extraordinarily focused on the unemployment rate and inflation as the two driving factors behind its actions.

A “Green Light “ for Risk-on Investing?
We think this decision prolongs the positive market environment we have seen in both equities and fixed income. With the Fed seemingly a distance away from tapering and raising rates, this could bode well for the risk sectors, where we could see further tightening in credit spreads on both high yield and investment-grade corporate bonds. We could see a reach for yield in securities that have suffered since the Fed’s comments in May. In reality, riskier markets have been only modestly affected by all of this talk of tapering. In fact , high yield and investment-grade corporate spreads are very close to where they were in early May, suggesting that the markets have recaptured almost all of the spread tightening and frothiness that occurred in the U.S. credit markets.

Globally, this should help alleviate stress in the Asian markets and some of the emerging markets in particular by taking some of the heat off the dollar. The dollar had been appreciating against these currencies and many of those investors were moving money out of those markets to the U.S.

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