6/20/13 – The Beginning of the End (of QE)

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jun 20, 2013 10:24:11 AM

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No prizes for guessing today’s topic. The Federal Reserve’s meeting ended yesterday with the usual statement and press conference by Ben Bernanke. But, as you could see from the market reaction, what was discussed was far from the usual.

For anyone who missed it, the Fed released a statement, which Bernanke amplified in his press conference, that a pullback from the bond purchasing program is indeed in the works. He even gave a target for when the Fed plans to start pulling back: at an unemployment rate of around 7 percent. To further support this, the Fed released more cheerful economic projections that suggest the pullback would start around the end of this year or so. The financial markets promptly sold off.

Whoops. What I think Bernanke was trying to accomplish was to give the market a smooth glide path into the Fed’s withdrawal from the markets. By setting an actual target, as unemployment edged down, everyone could start talking and preparing gradually. That way, when the exit actually started, it would be a nonevent, already priced in.

I suspect part of what prompted this path was the sharp market reaction to Bernanke’s remarks in May. After that, I suspect he and the Fed realized that any transition to less stimulus needed to be well telegraphed—because any sudden announcement would unsettle markets—and this glide path was supposed to do exactly that. Despite the Fed’s good intentions, however, the markets sold off anyway.

The immediate market reaction to the announcement has been twofold: interest rates are ticking up, and stock prices are ticking down. Why? Markets are forward looking, and traders are trying to get ahead of future movements. For interest rates, if the Fed will be pulling back, the time to sell is now, rather than when rates actually go up. That this actually creates the problem earlier is just an unfortunate side effect. As I’ve said before, part of the problem is that traders don’t have a good handle on what interest rates should be in the absence of the Fed. Markets have been so distorted for so long that there has really been no price discovery. Given that, discretion is the better part of valor.

Stock markets have the same problem, plus the very real concern that if the Fed pulls back, the recovery in the real economy may not be strong enough to continue without that support. If the real economy pulls back, the effect on the stock market could be twofold, with the repricing of risk combining with the effect on earnings of a weaker economy.

Part of the market reaction is the volatility that comes from any significant economic change, part is a real repricing of risk, and part reflects very real potential economic changes that will result from the Fed’s withdrawal. In the short term, I would not be surprised to see a continued pullback, as investors cautiously try to figure out the new landscape. After that, though, I would expect some recovery from the initial overreaction. There are reasons to believe interest rates may stay at low levels, even as the Fed pulls back, and once this becomes clear, caution may abate and prices recover.

One thing that does appear certain is that volatility will continue as investors attempt to understand the new world and continually overreact each way. I also suspect that, as investors struggle with the markets, their willingness to pay more for existing earnings will evaporate, suggesting that the stock market itself will continue to have more downside risk than upside.

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