How quickly everyone forgets. It was less than half a year ago that the market had a fit over the prospect of Fed tapering. At the time, many market participants argued that the economy could not stand on its own two feet without the constant Fed injections of copious amounts of quantitative easing. The idea that the Fed was going to taper this stimulus caused the market to throw a mini-tantrum out of fear of life without QE.
Although the Fed has worked hard to communicate the message that “tapering was not tightening,” the Fed has refused to deviate from its set course of reducing the QE program by $10 billion per FOMC meeting.
Contrary to the doomsday predictions, the market has not collapsed as the Fed has reduced the stimulus. In fact, just the opposite has occurred as the stock market has exploded to all time highs during the midst of the tapering.
And even more importantly, it does not appear that the tapering of the QE has had any noticeable affect on the economy.
The US economy continues to chug along, with Thursday’s great unemployment report highlighting the continuing economic improvement.
The previous two times that the Fed withdrew its QE stimulus, the economy had not reached the point where the economic recovery had become self sustaining. As soon as the QE was stopped, the economy (and the market) immediately rolled over.
This led many market participants to come to the conclusion that the US economy was incapable of growing without constant QE injections.
I have not been so accepting of this analysis. I never believed that monetary policy had become as ineffective as these pessimists forecasted.
I fully acknowledge that the velocity of money has declined much more rapidly than I would have ever guessed, but that with enough determination, a Central Bank can always overcome that decline. The only question is knowing whether they have stimulated enough.
The first two times that the Fed tried to stop QE, they had hoped that they had reached that point. But they ended up stopping short of economic self sustainability, and the economy returned to its debt destroying state.
This led the Fed to introduce QE3, which was the grand daddy of quantitative easing programs, with no end point given except that it would end when the Fed reached its goals.
Fast forward to today. The Fed has basically reached its goals and the economy is starting to gather momentum. The Fed is still loath to ease up on the gas pedal too quickly, remembering all too well the problems with QE1 and QE2 withdrawal. Those two times they also thought the economy had reached self sustainability, but they ended up being wrong.
They are determined to not make the same mistake again.
But the point that I want to stress is to realize that market participant are no longer debating whether the withdrawal of QE3 will cause the economy to roll over. Now most of the debate is centred around whether the Fed is allowing inflation to burn too brightly before raising rates.
This is a dramatic shift in market participants’ thinking. There is basically no one predicting that the end of QE3 will cause the same sort of economic and market sag that we experienced at the end of the two previous QE programs.
The tapering is no longer some super scary event that causes market participants to sit up all night worrying about the frightening prospects of life without QE.
New Jersey Shore hedge fund spin off hopefuls worrying about the end of QE3</a> </div>
Now that the market is no longer worried about the end of QE3 the real question is whether we should maybe be a little more concerned about this prospect.
I think it is important to differentiate between the economy and the stock market. Too many pundits seem to think that as goes the economy, so goes the stock market. Yes, at various points in the economic cycle they are indeed often in sync. However, there is no guarantee that they will be in sync during the coming recovery. In fact, it is one of my non-consensus theories that both stocks and bonds can go down as the economy recovers.
I will save the reasons of this potential decoupling for another day, but I want to point out the fact that QE is getting wound down and its effect on the day to day trading of the stock market is still very much intact.
Over the past few years, I have watched the trading in the stock market be propped up by the daily Fed QE purchases for too long to believe it is merely a coincidence.
S&P 500 (yellow line) vs Fed Balance Sheet (white line)</a> </div>
The expansion of the Fed’s balance sheet does not mirror the trading of the S&P 500 because of dumb luck. QE injections have a direct effect on the stock market.
Here at the MacroTourist, we track the daily returns of the stock market versus the Fed’s QE operations. We categorize the Fed days into days where they purchase less than $1 billion, more than $1 billion and no operation. Recently the no operation days have been somewhat limited, and the Fed often schedules big economic releases or Fed meeting days for non-operation days, so these days tend to be quite volatile.
But when we compare the daily returns of the S&P 500 on days where the Fed purchases less than $1 billion days versus the more than $1 billion days a clear pattern emerges.
|Month||QE Operation||SPX open to close||SPX close to close|
|May 2014||Less than $1 bln||+0.034%||–0.140%|
|May 2014||More than $1 bln||+0.236%||+0.333%|
|June 2014||Less than $1 bln||–0.017%||–0.106%|
|June 2014||More than $1 bln||+0.319%||+0.262%|
The more the Fed injects, the more the stock market rises. It is as simple as that.
And given that the Fed is methodically reducing the amount of QE should give the stock market bulls pause.
Have a look at the schedule for this month’s QE purchases:
Given that the Fed keeps reducing the amount of QE, there are less and less days where the Fed buys more than $1 billion.
In fact, after today’s $2.5 billion purchase, we don’t get another big POMO until July 23rd.
Although I do not expect the economy to roll over from the Fed’s tapering, I am not nearly as sanguine about the market’s ability to stay levitated without the Fed’s constant injections. I believe the Fed’s policies have pushed the stock market higher, and as they reduce the amount of stimulus, the stock market will at the margin suffer.
The fact that very few are worried about the Fed’s tapering does not bring me solace, and in fact, only reinforces my belief that the risk reward is still skewed towards favouring the short side.
Right now, I am short and wrong, but I am sticking with my position. We have only one more big POMO day before a two week break from the Fed’s injections.
I am going to leave you with the words from George S. Patton – “If everyone is thinking alike, then somebody isn’t thinking.” I am pretty sure if George were around, he would join me on the short side…