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By: Costas Bocelli — December 12, 2013

Here Comes the Taper!

“I’ll gladly pay you Tuesday for a hamburger today.”

Do you remember Wimpy from the old Popeye cartoons?  If you do, then you know that’s exactly how he racked up all those free lunches -- with countless broken promises to actually pay for his meals.

Wimpy also must have been part of the congressional negotiating process that was tasked with coming up with a longer-term budget agreement to replace the temporary spending bill that is set to expire on January 15.

In a deal announced after the markets closed on Tuesday, the bipartisan committee agreed to increase discretionary spending by $63 billion over the next two years above the previous levels that were mandated by the Budget Control Act of 2011.  If you recall, that was the law that allowed the debt ceiling to be raised and, in return, guaranteed $1.2 trillion in deficit reduction over the next decade -- otherwise known as “the sequester”.

It’s only been two years, and lawmakers are already reneging on that deal. 

But technically, they’re not.  You see, the new deal is structured in a way that the $63 billion over the next two years will be paid for by $85 billion in newly created revenues (fees) and additional cost savings (changes to entitlement benefits) over the next ten years!

So in the minds of lawmakers, the deal actually pays for itself and then some if you believe all the fuzzy math will actually come to fruition.

It’s "extend and pretend" ... hamburgers today for broken promises of repayment later.

The deal is far from a “grand bargain” and does nothing to seriously address the long-term fiscal shortfalls years down the road.

So it’s a wimpy deal for Washington, but a great deal for Wall Street!

Let me explain...

Dialing back the sequestration cuts by $63 billion over the next two years will significantly reduce the drag on the economy and blunt the impact on growth.

And since the deal funds the government for the remainder of this fiscal year and the next, it will greatly reduce the political uncertainty and avoid a repeat of the fiscal fiasco that forced a partial government shutdown in October. 

The one thing the deal did not address was the debt ceiling, which remains suspended until February 7, 2014.  The Treasury Department would likely be able to prolong its borrowing authority for some time beyond the deadline, but Washington will need to address this issue sometime in the first half of next year.

But that’s months from now, and the thing on the market's mind right now is the Fed and its $85 billion a month asset purchase program.

All Eyes on the Fed

In last week’s article, I wrote that the November jobs report may very well be the deciding factor as to whether the Fed will announce a taper at their upcoming FOMC meeting next week.

It turns out that the economy added 203k in new net jobs for the month of November, which was more than expected.  It wasn’t a blowout number, but strong enough to raise the three month average to 193k of new job creation.  That’s up about 40k from the trailing three-month average back in September when the Fed was considering a taper back then.

What was an eye popper was the fact that the unemployment rate dropped to 7.0% -- the lowest level in five years!  Last week, I suggested that if the unemployment rate would happen to drop to 7.1%, it may prompt the Fed to taper in December.

Economists polled by Bloomberg before the jobs report was released thought there was a 17% chance that the Fed would taper in December.  But after the jobs report, the new survey found that 34% now think the Fed will taper next week.

That’s a sharp rise, but still a minority among the economists.

As a trader who also tries to forecast future outcomes, I’ll take those odds and expect that the Fed WILL taper come next week.

Here’s why...

The labor market is showing signs of improvement across the board.

The budget agreement just struck will remove the fiscal uncertainty that the Fed specifically mentioned as a reason not to taper at their previous meetings.

The current pace of QE is far too much.  At $85 billion a month, that’s an annual pace of just over $1 trillion.  Coincidentally, when this program was put in place in late 2012, the Treasury was running fiscal deficits of the same amount, about $1 Trillion or so.  Yesterday, the Treasury Department reported that the government’s deficits are lower by 22% from the prior year through the first two months of the fiscal year already.  In essence, there is far less supply on the market and the Fed’s program remains unchanged.

The bond markets are behaving, as yields are responding to the Fed’s forward guidance on interest rates.  Sure we’ve seen a rise in yields on the long end of the curve, which should occur with an improving economy.  But the shorter end of the curve continues to remain well anchored as the two-year Treasury note yields just around 0.30%.

Lastly, it feels like the stock market has come down with another acute case of taperworm.  The S&P 500 just hit another all-time high on Monday -- the 39th record close of the year for the index.  But Tuesday and Wednesday saw the index post the worst two-day decline since early October amid the partial government shutdown.  The sell-off began with rumors of a budget deal was going to happen.

“Keep buying the Dip?”
 

So when you add it all up, the Fed is more likely to taper next week -- at least that’s my best guess.

What this Means for Stocks

The bullish trend has been strong, one of the best years on record.  There have been only a few opportunities to buy a dip, and most have occurred near the 50-day moving average or slightly below when you look at the S&P 500.

The next pullback may indeed be underway, as recent near-term overbought trading conditions continue to unwind.  This could be the last period of weakness for the year and the Fed’s FOMC meeting next week could be that inflection point.

The reality is that the market has already discounted the fact the Fed will soon taper QE, so if the FOMC announces a taper next week, that should ultimately be seen as a positive response.

So rip the Band-Aid off and just get it over with.  That would likely send the markets to yet another new high as more uncertainty is lifted from the market landscape.

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