The Fed Should Taper While Confidence is High

The Federal Reserve would be wise to consider tapering economic stimulus while investors have confidence in the approach and its results. Waiting too long could have deleterious results. Two negative outcomes immediately come to mind. The first would be a bigger equity market correction than necessary and the second would be a more dramatic spike in interest rates.

What is With the Value of Investor Confidence?

In the investing world investor confidence reigns supreme. It is always subtly present no matter how discrete. Every tool used by the Fed in supporting the economy and the markets relies on it. Why is this the case? Shouldn't markets be more rational? Not necessarily. Because markets are influenced by humans and humans are emotional, this tends to have a big impact on how markets behave.

Strike While Confidence is Still High

Friday, the equity markets sold off and many investors were rattled, as reflected by the biggest losses coming at the close. After two weeks of talk of possible early tapering, investors finally seemed to embrace "sell in May". Despite the late weakness in the equity markets, investor confidence remains high and the Fed is still getting the benefit of the doubt regarding the efficacy of its economic stimulus known as quantitative easing (QE). It's not too late for the Fed to taper and have the markets interpret it as the Feds confidence the economy is on a self sustaining path of growth. By doing this, it could be that markets rally in the face of tapering as investors see better economic growth and therefore discount higher future earnings. One negative alternative mentioned at the outset however is that investors lose confidence in the Feds approach and believe the Fed is being forced to taper before it wants to. This is a scenario where markets may sell off and possibly dramatically. Under this scenario, it's possible the bond market sells off and yields spike as a result and that the equity markets sell off  as investors seek the safety of the sidelines looking to book first half of the year gains. Early year gains in the equity markets create an environment where investors are more inclined to book profits and ride out a possible market correction which only exacerbates a sell off.

For this reason, it would be wise for the Fed to consider tapering earlier rather than later. If investors lose confidence and markets start to decline, tapering by the Fed may only exacerbate declines and result in harming both future economic growth and employment. Unfortunately, this is the part of the whole process that was expected to be the hardest to manage, the eventual exit of stimulus.