Make no mistake about it: Next week is all about the Federal Reserve. On Wednesday afternoon, the central bank is slated to release its most recent statement on monetary policy. The guidance therein will almost invariably dictate the direction of the S&P 500 (^GSPC 0.41%) for the week.
Since September of last year, the Fed has purchased $85 billion every month in long-term Treasuries and agency mortgage-backed securities in an effort to reduce long-term interest rates and thereby fuel the ongoing economic recovery. "The Committee is concerned," it noted at the time, "that without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions."
The impact has been particularly noticeable in the housing market -- which isn't coincidental, given that one of the Fed's objectives was to "support the mortgage market." At one point, the 30-year fixed rate mortgage even dipped below 3.4%, less than half of its long-term average, leading to a dramatic improvement in existing-home sales. In July, the number of previously owned homes that sold was up by 17.2% on a year-over-year basis.
But the tenor of this conversation changed in May after the Fed intimated that it could soon begin to taper its support for the economy. As Ben Bernanke noted in a question-and-answer session with the Joint Economic Committee on May 22, "In the next few meetings, we could take a step down in our pace of purchase."
Since then, virtually no economic release has been perceived but through the lenses of the central bank. "For the past several months, the stock market has been afflicted with a degree of schizophrenia," observed Tomi Kilgore of The Wall Street Journal on Friday. "On some days, weak news on the economy is good for stocks. On other days, it is strong readings on the economy that give stocks a boost."
With this in mind, while it's tempting to predict what will happen to stocks when the Fed does pull the trigger on a taper, doing so is fraught with peril. That said, there are two conclusions that seem safe to make.
First, long-term interest rates will head higher. In the short run, this will weigh on the balance sheets of banks including Bank of America (BAC 0.98%) and JPMorgan Chase (JPM 1.10%), both of which experienced multibillion-dollar write downs on their asset portfolios following the Fed's announcement in May. Over the longer term, however, the resulting expansion in their net interest margins should more than make up the difference.
Second, this will put further downward pressure on the housing market. Applications to refinance mortgages have fallen by 70% since the beginning of May. This development has led Wells Fargo (WFC 1.54%), the nation's largest mortgage originator, to predict that its home-loan volume will drop to roughly $80 billion in the current quarter, following seven straight quarters of $100 billion-plus in originations.