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Kass: Post-FOMC Strategy

"So come with me, where dreams are born, and time is never planned. Just think of happy things, and your heart will fly on wings, forever, in Never Never Land!"

-- J. M. Barrie, Peter Pan

Yesterday's tapering didn't surprise investors (who were almost evenly distributed in expectations), but the market's reaction (up dramatically) surprised many.

Before the FOMC decision, I was positioned market-neutral because I not only didn't have a strong view of whether tapering would be implemented -- albeit, I did not expect a tapering -- but I also didn't know how the market would react to the two likely Fed scenarios.

Would a tapering with the expected dovish forward guidance be seen as reducing the uncertainty and be cheered by the market? Or would investors be concerned that tapering would cause an unwanted rise in interest rates (consensus) and whack the markets?

Or would no tapering be viewed positively (interest rate stability) or negatively by the markets because of the uncertainty going forward (consensus)?

The FOMC Decision

The FOMC delivered a dovish statement on Wednesday. The stock market responded in a dramatic fashion, though bonds, the U.S. dollar and gold did not move all that much.

In my view, the S&P 500's rise was too strong given the FOMC statement and the response of other markets.

The Fed reduced its purchases of securities by $10 billion a month, to $75 billion a month; $5 billion less in Treasuries, to $40 billion; and $5 billon less in mortgage-backed securities, to $35 billion. I am a bit surprised that the FOMC did this in December (though economic data over the last week or so lifted my expectation of a tapering a bit) -- I thought January or March were more likely.

However, as I previously expected, the tapering announcement was accompanied by dovish forward guidance.

The dovish forward interest rate guidance was "the committee now anticipates that it will likely be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines well below 6.5%, especially if projected inflation continues to run below the committee's 2% longer-run goal." This statement was dovish from two vantage points:

1. The FOMC had been saying that a 6.5% unemployment rate was a rate at which it would consider lifting the fed funds rate -- the current statement says "well below 6.5%" before FOMC will consider lifting the fed funds rate.

2. The statement today elevates the inflation rate, and this rate is expected to stay below the 2% target through 2016.

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