Slowing Down

Monday 02/03/14

     Last week most stocks were slightly lower as emerging market concerns continued to weigh on stocks. Global liquidity will likely decline further as the Fed voted to reduce its bond purchases by another $10 billion dollars, the Fed will now be purchasing $30 billion of mortgage backed securities and $35 billion dollars worth of treasuries each month. In their press release, the Fed stated that, “The Committee's sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee's dual mandate.” While it is important to remember that the Fed is still increasing quantitative easing, it is even more crucial to understand that the market is more interested in the rate of change.

     I think that quantitative easing is best viewed through a metaphor. Imagine that you are in a car going 85 miles per hour. You begin to take your foot off the accelerator and reduce your speed to 75 miles per hour. You are still making forward progress, but it will take you longer to get to your destination. If you have ever spent a lot of time driving in empty country roads, you can probably relate to the feeling that you get when you have been going very fast and then have to slow down when you come to a town. You may be going 45 miles per hour still, but for some reason it feels so much slower. This is the current situation that we are in with QE. The fed isn't slamming on the breaks, they are just easing up on the gas. This won't have the jarring impact that tightening will have, but it just won't feel as good.

     The market is a leading indicator (albeit with a lot of quirks). In June, the bond market began to anticipate Fed tapering. The market did not wait for the actual tapering event, interest rates began to rise immediately. This rise caught many investors by surprise (myself included). However, now that tapering has actually started, interest rates are going lower again. This may be because the market over-anticipated the impact that tapering would have on bond prices. If treasuries are scarce and in demand, then interest rates should move lower. Tapering doesn't increase the abundance of treasuries, but it does lower the rate at which the Fed is making them artificially scarcer.

     So why all this focus on rate of change? Let's go back to the car metaphor once again. If you plan a road trip under the assumption that the speed limit will be 75 miles per hour, your calculations will be wrong if traffic forces you to go 65 miles per hour instead. The market initially anticipated that quantitative easing would last forever, which is why it was referred to as QE infinity. However, the market had to quickly recalculate its assumptions in June when it realized that QE infinity might not be so infinite. The market over-corrected and raised bond yields too much. The market is like the GPS that has to constantly recalculate based on the changing traffic conditions.


     Now that tapering is known, the market will look to the rate of change at which QE is removed. The current assumption is that the fed will continue to reduce purchases at a rate of $10 billion per month. The fed has also given specific targets regarding interest rate increases such as, at least 6.5% on the unemployment rate. The fed has stated that they will be data dependent on numerous occasions, so a surprise announcement of more QE or even no change will benefit the markets (especially bonds) whereas a faster reduction will cause the market to make faster adjustments to its calculations.
Index Closing Price Last Week YTD
SPY (S&P 500 ETF) 178.18 -0.49% -5.7%
IWM (Russell 2000 ETF) 112.16 -1.42% -5.82%
QQQ (Nasdaq 100 ETF) 86.27 -0.58% -4.17%

The S&P 500 Index and Total Fed Assets

This chart shows the relationship between the Fed's balance sheet and the returns of the S&P 500 index. Data from the St. Louis Fed.

Changing Rate of Change

This chart shows the second derivatives of both the S&P 500 and the Fed's balance sheet. This may give some insight into the role that the rate of change plays in determining asset prices. Data from the St. Louis Fed.