Don't fear the Fed: Four reasons to embrace the taper

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Stocks have hit some turbulence this week, and it's tempting to pin the blame on a streak of upbeat economic news: Rising payrolls (boo!), falling unemployment (hiss!), improving retail sales (come on!) and a two-year budget agreement in Washington (enough!).

Together, this good news builds a case for the Federal Reserve to taper its bond-buying program, known as quantitative easing or QE, as early as next week – and definitely by early next year.

Investors aren't so sure what that will mean for a stock market that has relied upon Fed stimulus over the past several years, and they can now point to the Dow Jones Industrial Average's three-day, 286-point tumble as a reason to be nervous.

But strategists see little long-term threat from tapering. And while you might dismiss these assurances as typical Wall Street optimism, they have a point.

Strategists at Pavilion Global Markets believe the Fed will taper its monthly bond purchases in late January, and they expect the central bank will drop heavy hints about the move at the conclusion of next week's monetary policy meeting.

"That the taper is coming is well understood," the strategists said in a note. "What isn't explicitly known, however, is the impact that the taper will have on the economy and on markets."

Their advice to investors: Don't fear the Fed. And they back up this view with four points.

1. Under incoming chair Janet Yellen, the Fed isn't going to commit to any sort of calendar-driven schedule for unwinding stimulus, but rather will use "outcome-based guidance" – giving the central bank far more flexibility in how fast it unwinds.

This should prevent the market from pricing in tapering, and should soften the overall impact.

2. The initial impact of the taper has already been priced in, due to the considerable taper-talk heard earlier in the year that sent interest rates spiking and triggered volatility in emerging markets.

"Some of this price movement has unwound since September, yet there has not been a full return to pre-TaperTalk levels," the Pavilion strategists said.

For example, the yield on the 10-year U.S. Treasury bond surged to 3 per cent by September, from 1.6 per cent in May. Today, the yield is just below 2.9 per cent.

As well, the market has been showing some signs of welcoming good economic news: Stocks rallied last week after the U.S. Department of Labour reported big job gains in November and a drop in the unemployment rate to a five-year low of 7 per cent.

Although the rally has since stalled, the initial enthusiasm suggests that investors are okay with tapering if it is accompanied by an improving economy.

3. Winding down asset purchases will come with a lot of hand-holding. When markets turned turbulent earlier this year after tapering was first mentioned, investors feared that rate hikes would soon follow.

This time, the Fed will offer continuing support, perhaps by saying that an unemployment rate falling below 6.5 per cent won't be the trigger, or by trying out new tools. One option is for the Fed to cut the interest on excess reserves (or IOER), providing a signal that it will keep its key interest rate lower for longer.

4. Any communication from the Fed about a taper should be accompanied by references to the strength in the U.S. economy – particularly industrial production, consumer confidence and the end of the balance sheet recession, where U.S. households start to borrow again.

"This is, in our view, the foremost tailwind to U.S. growth and the financial system heading into 2014," the Pavilion strategists said. "Our expectation that the Fed will explicitly acknowledge improved growth prospects such as these will also help to temper the fear of less easy monetary conditions."

In other words, quantitative easing was good. But an improving economy is even better.