Understanding QE
Quantitative Easing (QE) involves pumping freshly printed electronic dollars
into the hands of the Fed's primary
dealers in exchange for bonds. A bond is removed from the economy and new
money is added. If the Fed is on track to reduce/eliminate QE in the coming
months, what is their game plan for protecting against a panic-induced spike
in interest rates? How will this strategy impact the stock market?
It's Okay - We Plan To Keep Rates Low
Many hold the opinion that QE will never end, since they believe the economy
will continue to grow at a tepid pace. As we have argued in the past, tapering
is about bubble
management, rather than a reaction to economic strength.
Fed mouthpiece, John Hilsenrath, penned the following in Saturday's Wall
Street Journal:
One option that has gained support among some Fed officials in recent
weeks: Reduce monthly bond purchases by a small amount, say by $10 billion,
to $75 billion a month, and signal as loudly as possible the next step
will depend on more evidence the job market is continuing to improve and
inflation is moving back toward 2% from its current low levels.
As Dallas Fed head Richard Fisher has noted, QE "can't go on forever". For
stock and bond investors, the Fed's current track involves questions of "when" rather
than "if" tapering will begin.
Bulls Still Have Some Good Looks
The charts have had a bearish bias in recent weeks. Looking at bullish scenarios
allows us to see a broader range of possible outcomes for stocks. One bullish
scenario for equities considers a delay in the decision process relative to
Syria and the fact that the next Fed statement is still almost two weeks away.
This week's video examines numerous pieces of "glass half full" evidence, while
noting the markets remain in a fragile and tentative state.
Fed Is Concerned About Interest Rates
Our guess is there have been some sleepless nights for Fed governors in recent
months. They already feel 2013 looks too much like 1994,
where rising interest rates helped push stock and bond prices down simultaneously.
From the Wall Street Journal:
Officials have concluded over several months of market volatility that
it matters immensely what signal investors take from their actions. They
are deeply concerned that any move to scale back the bond-buying program
even by a small amount could be seen wrongly by investors as a broader
sign that their easy-money policies are ending, which could push long-term
interest rates up even more and undermine the recovery they've been trying
to encourage.
A Tough Sell
The Fed's course of action is always well-planned in advance. The clear message
since the late May utterance of "tapering" from Chairman Bernanke's lips has
been, we plan to taper, but we also plan to keep interest rates low for
an extended period.
It is noteworthy Hilsenrath's WSJ piece concludes with the following:
The Fed's post-meeting policy statement and Mr. Bernanke's post-meeting
press conference are likely to emphasize that short-term interest rates
will remain near zero until the jobless rate falls much further and that
future reductions in bond purchases aren't set in stone.
Even after Friday's labor report, the script remains "tapering is coming,
but also with a strong pledge to keep interest rates low."
Investment Implications
The financial markets remain indecisive and confused. The confusion could
be seen in Friday's volatile trading session. The S&P 500 closed 10 points
off the intraday high and 14 points off the session low. What did all the intraday
volatility produce? No consensus either way; the S&P 500 was basically
flat when the closing bell kicked off the weekend.
Our market
model did see incremental improvement during the week. Consequently,
we increased our exposure to broad market positions (SPY), taking an incremental
step back toward risk. We have held small caps and technology (QQQ) through
the recent pullback. As shown below, the NASDAQ has held up relatively well
from a weekly trend perspective.
Similarly, small caps (IWM) have continued to provide leadership, but momentum
has slowed recently.
If the Fed is concerned about the market's reaction to tapering, it seems
logical that investors should be concerned as well. Similarly, if the Fed is
unsure of how the stock and bond markets will react to news of a punch bowl
reduction, it seems logical to adopt a flexible and open-minded stance until
some clouds begin to clear. If we pay attention to the market's pricing mechanism,
we will never stray too far from a prudent mix between risk and conservative
assets.
