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Craig Allen: Is Good News Bad News for Financial Markets?

This past week’s jobs report showed 204,000 new jobs added to the U.S. economy, with an additional 60,000 jobs added to September and August collectively. Although the unemployment rate ticked up slightly to 7.3 percent from 7.2 percent, this positive jobs report sparked the beginning of what may likely be an ongoing debate over the significance of improving economic data. Positive economic news may very well push the Fed to begin tapering much sooner than most economists currently believe is likely.

Most economists expect the Fed to continue buying $85 billion in bonds each month through March. The beginning of the tapering process was pushed out from the previous expectation of a December start to tapering after the government shutdown, which certainly weakened the pace of the economic recovery, and will hurt GDP growth in the fourth quarter.

Janet Yellen, President Barack Obama's nominee to chair the Federal Reserve, will testify before the Senate Banking Committee this week. Fed watchers and investors will be watching for any signs of deviation from Fed chairman Ben Bernanke’s dovish stance on providing stimulus to the economy. Yellen finds herself in a tough spot; if she intends to place her own stamp on the Fed chairmanship, she will want to differentiate herself from Bernanke. But if she deviates materially from Bernanke’s established course with regard to stimulus and rate policy, she could roil markets.

The Nasdaq finished flat for the week at 3,919, recovering 1.6 percent Friday, while the Russell 2000 was up 0.4 percent for the week, gaining 1.9 percent Friday. Both those indexes had been diverging, declining while the Dow and Standard & Poor's 500 rose and falling harder when they declined.

The bond market is closed Monday for Veterans Day, with the 10-year treasury closing-out last week at a 2.75 percent yield. Interest rates spiked on Friday after the jobs report, throwing the threat of another breach of the 3 percent level for the 10-year treasury back on the table. The last time rates pierced 3 percent, peaking in early September, stocks experienced a sizable sell-off, falling to 1,630 (S&P 500) from 1,710, or by almost 5 percent.

Positive economic news, like the jobs report, will pressure the Fed — and especially Yellen — to move up the beginning of the tapering process, possibly as soon as their next meeting in December. While GDP growth and retail sales will likely suffer somewhat from the government shutdown, the impact may not be enough to significantly impair the economic data, especially jobs for November. A good November jobs number of 200,000 or better could be all the Fed needs to pull the trigger on tapering.

One possible way to view the predictability of the impact of positive economic data on the Fed’s decision-making process is to look at the perspectives of the Fed membership. In addition to Yellen’s hearing this week, several other Fed members will offer their two cents on the economy. Some on the Federal Open Market Committee, the body of the Fed that makes decisions on stimulus and rates, have already indicated their belief that tapering should come sooner rather than later. One could argue that at least some FOMC members are looking for any positive signs within the economic data to serve as reason enough to begin the tapering process.

Another key aspect of the Fed’s role in guiding the economy that has received less media attention lately, but that will become increasingly important, is the level of short-term interest rates. The Fed has maintained a Fed Funds rate at a range of zero to 0.25 percent since December 2008. It's not clear at this time whether the Fed will begin tapering first, or will begin to raise short-term interest rates. My personal belief is that the Fed will taper its bond-buying program first, but that a small rise in short-term rates will likely come shortly thereafter. The combination of removing stimulus and raising short rates, will place considerable pressure on stocks.

In my opinion there is no easy way to withdraw the massive amount of stimulus the Fed has been pumping into the economy since the summer of 2012. The U.S. economy is the largest in the world. Changes to Fed policy typically take two or more quarters to show any impact, making it extremely difficult for Fed policy makers to forecast exactly when they should make changes. The longer the Fed continues to pump stimulus into the economy, the greater the risk that inflation will grow beyond the acceptable range. If history is any guide to Fed policy, inflation has been the most concerning consequence of economic stimulus programs.

If we're going to suffer a significant negative reaction in the financial markets to the removal of stimulus, regardless of when it takes place, I would much prefer to get it out of the way sooner rather than later. Yellen may also prefer to get the taper process under way as soon as possible as well, so that she has more time to build a positive legacy for her tenure as Fed chairwoman.

If the 10-year treasury rate rises above 3 percent, the Fed may feel that the timing is ripe for pushing forward with tapering sooner, since financial markets may correct in anticipation of the inevitable. A rise above 3 percent may precipitate a correction in stocks, possible down to the 1,650 level, which is near the S&P 500’s 200-day moving average. If economic data continues to improve, a pull-back to this level may be followed by another run to the upside, possibly above 1,800 to as high as 1,850.

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here to read previous columns or follow him on Twitter: @MPAMCraig. The opinions expressed are his own.

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