Will the Fed end the bond buying?
It all comes down to this.
More than six years after starting to load up on mortgage and U.S. Treasury bonds in a bid to boost the sagging economy, the Federal Reserve looks set to pull the plug on the program. The policy, known as "quantitative easing," has taken the central bank's monetary base from $600 billion before the recession to more than $4 trillion now, holding down interest rates and accumulating about a third of all outstanding long-term government debt.
Such is the lengths Fed policymakers have gone to reinvigorate the economy still healing from the bursting of the housing bubble so many years ago.
On Wednesday, after steadily tapering the pace of monthly bond purchases over the past year, the Fed is expected to say whether it will halt the program, as it previously signaled. The expectation is that with the unemployment rate falling to 5.9 percent last month and U.S. economic growth strong over the past year (average annualized growth rate of 2.6 percent) the program will end.
But there is always room for a surprise.
The Fed's September policy statement was considered "dovish" since it highlighted weak economic performance overseas and the risks to the U.S. economy of the recent strength in the U.S. dollar. Since then, the stock market suffered its worst rout in years, driven largely by bond market turbulence as investors prepare for the possible end of the bond buying. High-yield corporate bonds in particular have been rattled, as shown below.
And let's not forget that politics could play a role, with the Fed no doubt cognizant of the midterm elections less than a week away. Finally, the Fed has pulled a surprise before: Last September, when the consensus strongly expected the Fed to start cutting its bond purchases, it surprised the world by waiting until December to start the tapering.
So it's possible that the bond buying continues until the Fed's next meeting in December, which will also feature a press conference from Fed chairman Janet Yellen. But even if they pull the trigger and end the stimulus, it's still possible for the markets to react favorably.
For one, big Fed events are almost always considered a positive catalyst for stocks. Policymakers understand how sensitive markets have become, especially after the recent selloff, and will be loath to rattle investors heading into the important holiday shopping season.
Moreover, when the first two rounds of the bond buying stimulus ended, the result was temporary market turbulence and a loss of economic momentum. The Fed will want to avoid a repeat.
Finally, there is a big and growing gap between the bond market and Fed policymakers regarding where interest rates will be headed in 2015 and beyond. The Fed is much more confident, and sees rates rising sooner and faster than traders do. Either the market is wrong, or the Fed is wrong.
Given all this, I'm looking for the Fed to lower its forward guidance on rates to more closely align with where the bond market is. This will likely be accomplished in the wording of the policy statement by talking up downside risks to the economy, especially the fact that inflation remains well below the Fed's two percent target and is moving in the wrong direction as shown above.
The outside risk is that the Fed ends the long-term bond buying and sticks to its guns on the timing of its first short-term interest rate hike since 2006 -- which it currently sees happening around the middle of 2015. Stocks would react negatively, in this case, and bonds would be hit hard setting the stage for a retest and possible break of the market's October lows.
But with the inflation threat nonexistent, markets nervous and wage gains yet to appear, this is an unlikely outcome. Instead, look for the bond purchases to end and the Fed to highlight the fact that short-term interest rates, which have been near zero percent since 2008, will remain low for a long time to come.
With the stock market closely following the increase in the monetary base associated with the Fed's bond buying, it's an open question whether this will be enough to keep stocks on the path to new record highs.
The upshot: After two years of relative calm, things are poised to get volatile as the Fed removes its stimulus and lets the economy find its feet.