I am going take a stab at explaining what I think is happening in the markets. There seems to be a bunch of analysis that is mixing up cause and effect.
Let’s take a step back and think about the Quantitative Easing programs. What were the effects of those programs? Well, at their core, QE programs are inflationary. The programs increase the monetary base upon which banks and other credit conduits can lend.
The problem was that, coming out of the 2008/9 credit crisis, the velocity of money declined faster than the Fed could shovel it out the door. This forced the Fed to engage in multiple QE programs in an attempt to offset the credit destruction in other areas of the economy. But even though there were deflationary headwinds, QE programs definitely had an effect on the economy. They increased the monetary base and caused more US dollars to be pushed into the system than would otherwise have been the case. If you increase the supply of something, its price generally declines. Which is why during the heavy periods of QE, the US dollar would often decline. If you continue to push credit into the system, the marginal effect of those injections might decline, but it still pushes up prices somewhere. In the cases of the Fed’s QE programs, at first it found its way into gold and other traditionally “inflationary” items. However, it eventually worked its way into financial risk assets. Towards the end of the third QE program, the liquidity seemed to be flowing solely into stocks and other higher risk fixed income instruments.
When the first QE program ended, the Fed mistakenly believed that since they had enlarged the monetary base to such a great extent, the multiplier effect of the banks lending would cause credit to continue to expand. But they did not understand the massive balance sheet recession would weigh so heavily on credit creation. The decline in the velocity of money overwhelmed their expansion efforts. The moment the Fed stopped its QE programs, the deflationary backdrop remerged. Risk assets sagged, and even though most market watchers ignore this fact, bonds rallied. And this reaction makes sense because QE programs are inflationary. In an over indebted economy, without inflation, stocks will sag and bonds will rally.
The Fed, sensing that they were wrong in their assessment of the extent of the problem, quickly introduced QE2. With the liquidity getting pushed back into the system, stocks resumed rallying and bonds sold off.
When the Fed tried to wean the market off QE2, the same thing happened. This eventually brought on QE3, which was nicknamed QE infinity because this time the Fed did not state an amount they were going to buy in advance, but instead said they will keep buying until their economic targets were met. This was the “we are going to inflate” or else moment.
That program was introduced on September 13th, 2012. For the next year and a half, the Fed steadily pushed credit into the system.
At the end of 2013, Bernanke finally got around to putting the Fed on a schedule to taper down its purchases. The Fed was rightfully worried about a repeat of the end of QE1 and QE2, so they decided to not try the cold turkey again.
Ever since that announcement, the Fed has gradually reduced the amount of their injections by $10 billion per month. So although they are still adding liquidity to the system, they are gradually adding less and less.
Which brings me to my explanation about what is going on in the markets. Remember that QE programs are inflationary? And don’t forget that inflation is the bond market’s greatest nemesis.
It is therefore no surprise that since the tapering announcement at the end of 2013, bond yields have declined (bond prices rallied).
Bonds figured out quickly that tapering was a reduction in the inflationary stimulus, therefore it was bond friendly.
Since then, as the Fed has tapered the liquidity flow, other markets have slowly started to react.
At first it was the most liquidity sensitive markets that rolled over. Commodities, which
are very dependant on abundant global liquidity, rolled over at the start of summer.
With the rate of US dollar expansion slowing down, the FX market was the next one to figure it out.
In mid-summer, the US dollar started a rally that is still going strong. That makes perfect sense. If you slow down the expansion of US dollars credit, then it will cause the supply to also slow, and for the US dollar to rally.
From there it wasn’t long before other liquidity sensitive markets like US small cap equities slumped.
The ticked at the high during the summer months, and we are hitting new lows all the time today.
High yield bonds were much on the same track.
And junk bonds are almost identical looking.
As time has progressed, and the Fed keeps turning down the rate at which they are letting out liquidity, it has spread its way through the global financial system. This month Emerging Markets sold off quite hard.
And the drying up liquidity also weighed on the emerging market bonds.
The Fed’s withdrawal has one by one, dragged down the most liquidity sensitive markets.
But so far it has barely had an effect on the S&P 500.
Although we have come off a little bit during the last couple of weeks, the trend is much stronger compared to other risk assets.
And it isn’t really just a large cap value strength issue. An even better performing index has been the Nasdaq.
Which brings me to my explanation about what is happening in the markets. Global financial markets are reacting to the gradual withdrawal of liquidity addition from the Fed. Yes, I know that the Fed is not withdrawing liquidity, but instead merely slowing down the rate at which they are adding to it. But prices move from the marginal change, so that slowing down is important.
QE programs are inflationary – what prices they inflate is difficult to determine, but there is a definite effect to the Fed’s injections. As the Fed slows down and stops the injections from QE, the markets most sensitive to this liquidity are suffering.
At the end of the first QE program there was a big debate amongst economists about whether the flow from the Fed’s balance sheet was more important than the size. Many economists fell into Bernanke’s camp that the size of the balance sheet was more important than the flows. I believe the reasons for their error was an assumed constant monetary velocity. They believed that if they increased the monetary base by a certain amount, they would get a certain forecastable private sector response. But that didn’t happen. Therefore the Fed was quickly forced to keep expanding its balance sheet.
We are going to be faced with this same problem next month when the Fed stops expanding its balance sheet. Will the sheer monster size of the Fed’s balance sheet finally ignite the spark of private sector creation? Will the velocity of money stay constant and maybe even accelerate? Or faced with a Fed that no longer actively inflating, will the private sector resume its trend of credit destruction by paying back debt?
Does the relative strength of the S&P 500 and Nasdaq signal that the US is finally ready to stand on its own? Have we hit the elusive escape velocity?
Or are these simply the last two soldiers standing as the oxygen is slowly sucked out of the room by the Fed? One by one the other markets have rolled over, are these two the next up?
The market action over the last few months has been entirely consistent with a Fed that is winding down its QE program. From here, we are going to get to the point where the markets need to stand on their own. Whether they are up for the challenge or not remains to be seen. I don’t have the answers to this question, but given the ongoing problems in the global economy, I think the Fed is going to take any rate hikes very slowly.