On Wednesday, the Federal Reserve announced that it would be tapering its bond buying by another $10 billion per month, bringing the net monthly purchases down to $35 billion per month. It also announced that it had revised its economic forecast downward to a range of 2.1 percent – 2.3 percent from its previous estimate of 2.8 percent to 3 percent, and it cited the bad weather in the first-quarter as the justification for the economic downturn. It also adjusted its core inflation estimate for the year to 1.5 percent – 1.6 percent to 1.5 percent – 1.7 percent.
Investors were largely optimistic on this news: they bid up stocks about 2/3 of a percent. Bonds, however, were even stronger on the day: the iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT) rose by 0.77 percent.
It is unclear why, exactly, both stocks and bonds rose on the day. Since the bottom in March 2009, stocks have traded in lock-step with the Fed. If the Fed was easing, then stocks would rise. When the Fed stopped quantitative easing in 2010 and in 2011, stocks retreated. Since the Fed started tapering stocks have risen, but they have risen at a much slower pace than during the height of QE3, which leads me to believe that when tapering stops that, once again, we will see stocks decline. The fact that we are one step closer to the cessation of quantitative easing — and the fact that further tapering increases the probability that we will reach that point — tells me that stocks should have declined.
The strong performance in bonds is a complete mystery. The logic behind bonds dropping on further tapering is simple — fewer bond purchases means less demand in the market, and this should have a negative impact on prices. However, the bond market has been rising relentlessly this year despite tapering and despite declining demand coming from abroad — particularly from Russia and from China.
Despite these counterintuitive market movements, I think investors would be wise to avoid rationalizing them and stick with the simple conclusion that tapering and eventual cessation of QE3 will lead to a decline in stock and bond prices. Thus, in the next few trading sessions, it might be wise to take some profits in some of your better performing stocks, especially if they trade at rich valuations (e.g. greater than a 20 price to earnings multiple.)