A Preview of What Will Happen as Feds Pull Back on Money Printing

By Sasha Cekerevac

There’s nothing a market hates more than uncertainty. Investors, both large and small, build a model from which they can then generate an investment strategy. The greater the uncertainty, the more difficult it is to come up with an investment thesis.

Over the past few years, the Federal Reserve, through its aggressive monetary policy stance, has tried to reduce uncertainty and bring confidence back to the stock market. But due to the long period in which there has been a lack of volatility, this has brought complacency into the market—a dangerous situation for investors.

Many believe that once the Federal Reserve begins to reverse its monetary policy stance, starting with tapering down its asset purchase program, it won’t have a deleterious effect on the market. But I disagree. Because much of the recent move up in the stock market has been built off expectations that the Federal Reserve will continue its monetary policy program for an extended period of time, I believe any shift in this initiative will cause a significant pullback in the market.

An example of the type of volatility that could hit our stock market is the recent volatility in the Japanese market. Japan has embarked on a journey similar to that of the Federal Reserve’s; by creating a very aggressive monetary policy program, Japan is trying to get out of its deflationary spiral and create some inflation.

The market has reacted positively to this news, with the Nikkei up approximately 60% just this year. However, last week saw a drop of more than 10%, as uncertainty increased substantially. There were a variety of reasons, one of which was a reaction to the minutes from the last Bank of Japan meeting.

Chart courtesy of www.StockCharts.com

As monetary policy was discussed, several members of the Bank of Japan (BOJ) raised conflicting concerns and expectations. (Source: “Minutes of the monetary policy meeting,” Bank of Japan web site, May 27 2013.)

The BOJ is currently purchasing Japanese government bonds with the result of downward pressure on interest rates. However, the BOJ’s goal for increasing inflation levels would have the effect of increasing interest rates, as investors sell government bonds. This contradictory message in the potential outcome of its monetary policy was reflected in the markets as volatility increased.

Will the Federal Reserve be more successful in not only communicating, but also enacting changes to its monetary policy program? I doubt it, since many market participants would most likely rush for the exits.

The problem is that many Federal Reserve members aren’t sure which way monetary policy will move next. Recent comments by the president of the Federal Reserve Bank of New York, William Dudley, show the extent of uncertainty, even among the Federal Reserve members.

Dudley stated that because of the uncertainty regarding the economy, he wasn’t sure if the Federal Reserve will expand or reduce monetary policy. Others, such as the president of the Philadelphia Federal Reserve, Charles Plosser, have called for a reduction in asset purchases through the monetary policy program as soon as next month. (Source: “Dudley says he can’t be sure if next QE move is ‘up or down,’” Bloomberg, May 21 2013.)

If the Federal Reserve presidents aren’t certain of the future regarding monetary policy, it becomes increasingly difficult for investors to properly allocate their capital.

Investors should be prepared for a significant pullback once the Federal Reserve makes any shift toward reducing its monetary policy program. While the economy still appears relatively weak, we can’t simply ignore comments from Federal Reserve presidents stating they are inclined to begin reducing monetary stimulus shortly. I don’t believe they will begin tapering it off next month, but the Fed members wouldn’t have said it unless they meant it—so we should begin adjusting our portfolios accordingly.

This article A Preview of What Will Happen as Feds Pull Back on Money Printing was originally published at Investment Contrarians