Era of Fed Stimulus Wanes

March 31, 2013, 12:08 p.m. ET

Era of Fed Stimulus Wanes

By CYNTHIA LIN

Between U.S. stocks reaching highs and Treasury TWE.AU -0.35% yields holding near all-time lows, one of these two contrary markets will eventually have to give.

At the moment, the Federal Reserve’s easy-money policy makes it so that there is enough to go around, bolstering risky and haven assets alike. But the more the U.S. economy improves, the closer investors get to a financial marketplace with less Fed support that can sap the strength from one of these markets.

Entering the second quarter with a fresh batch of key economic data on deck, investors will get evidence as to whether the U.S. recovery this year can defy the downturn suffered in each of the past two springs. Hand in hand with that will be whether and how the Fed reacts by adjusting its $85 billion monthly bond-buying program.

“We are getting closer to the end,” John Brynjolfsson, managing director of global macro hedge fund Armored Wolf LLC, said of the Fed’s stimulus efforts. “Discussion of tapering helps to make the exit less of a digital on-off decision, and should allow the Fed to more gradually wean the markets off its support.”

Mr. Brynjolfsson owns put options on the Standard & Poor’s 500-stock index to hedge against a sharp drop in equities, while also positioning for a fall in Treasurys prices against German bund prices.The S&P 500 closed at a record 1569.19 Thursday as investors showed faith in the U.S. recovery, brushing off concerns about Italy’s struggles to form a new government and Cyprus’s controversial bailout plan.

But at the same time, the Treasurys market told a somewhat different story with its 0.1% total return in March—a sign that demand for financial safety persisted. Benchmark 10-year notes yielded 1.85% late Thursday, not far from the 1.4% historic low set last July.

As long as the Fed keeps injecting the economy with cheap-to-borrow money, traders say there is room for both stocks and bonds to perform well. But an eventual divergence will come when it becomes clearer the Fed is poised to pull back.

One case is if investors are convinced the economy is strong enough to grow without Fed support, a scenario that likely keeps stocks headed higher and drags Treasurys down. If investors deem the Fed’s withdrawal premature, stocks will likely tumble and route demand to Treasurys. The latter scenario happened a number of times in recent years, when one Fed asset-purchase program ended without a new one starting.

Investors will have plenty to digest this week with fresh indicators on the U.S. labor market and manufacturing sector. Friday’s nonfarm payrolls report for March, in particular, is central to the economic picture because the Fed said it will consider raising the policy rate only after the unemployment rate falls below 6.5%.

Economists surveyed by Dow Jones Newswires expect 200,000 private-sector jobs to have been created in March, with the jobless rate remaining at 7.7%.

Such a result reflects slow progress and should keep the central bank committed to pushing full-steam ahead with its stimulus program. New York Fed President William Dudley said in a recent speech that even if at some point the Fed dials down the pace of purchases, it could be dialed back up if economic conditions recede.

Michael Lorizio, senior trader at Manulife Asset Management, said he believes the Fed will continue buying bonds at its current pace through all of 2013, at least. “Dialing down purchases is effectively a tightening of policy, and the Fed seems to be committed to not tightening prematurely,” he said.

Chicago Fed President Charles Evans, an outspoken supporter of bold easing efforts, and Kansas City Fed President Esther George, a dissenter of the current policy, are each scheduled to make remarks this week. Both are voting members of the Fed’s policy-setting board.