The 5 Trillion Dollar Question
2014 has been a volatile year to date. The amazing returns of years past are definitely not on the boards just yet and the longer the stock market hesitates, the higher the odds are for it to go lower. Consequently, the uncertainty is increasing daily amongst investors and not much would be needed to completely destroy their (renewed) faith; the sell button is certainly seeing a lot more action these days in online brokerage accounts.
A short break also gives us the opportunity, however, to investigate the big picture once again, as the underlying issue of this faltering market is not the change of a single digit in the year (like changing seasons), but a deeper, fundamental reason. What stopped the market in its tracks, namely, is the Fed’s QE program being scaled back. On the 18th of December, to be exact, the US central bank started ‘tapering’ and things are moving along swiftly. Last year, the Federal Reserve bought 85 billion USD of mortgage debt and government bonds every month, but at the moment that monthly figure has gone down to 55 billion USD. According to insiders, the Fed even wants to put an end to QE before the year is over.
The way things are looking now the Fed’s balance sheet will stop its explosive growth quite soon as a consequence of this target, although we did pass the 4 trillion USD mark recently.
Over the coming months a few hundred billion dollars will still be added to the Fed’s balance sheet, after which the party would be over. In theory. In practice we can already see the effects of tapering as well, as the stock market rally of these last few years was completely built on the monetary assistance of the central bank. The Fed wants the market to stand on its own two feet, but whether that is actually going to happen is, of course, another matter.
The market is a fickle creature, not easily swayed, and especially not when downside pressure is in the mix. Most investors remember the downward spiral of 2008 like it happened yesterday as the markets fell by a couple dozen percentage points in just a few months and the Fed does not want that to happen twice, we assure you. As a consequence, the central bank will have to choose its words and deeds very carefully and we assume that there is actually some wiggle room in the tapering process. The Fed could, for example, take a short break from tapering, although it is clear that this monetary insanity needs to stop at one point. Most likely, the Fed drew a line in the sand around the 5 trillion dollar mark.
The real question is then: if the Fed will definitively put a stop to QE, will investors be able to keep the stock market rally alive on their own? Time will tell, but the Fed possibly has a few more tricks up its sleeve to put the new dollars that have been created over the last few years to work effectively as most of it is currently parked on the central bank’s balance sheet. The Fed could, for example, raise its interest rates on bank reserves as the banks are barely paying anything today and if that new money is going to be pumped into the system through fractional banking, there is a lot more upside to the market. But that is a trajectory that also carries risk for the Fed as it still has control to some degree over where the money is going now, but once it leaves the balance sheet of the central bank, it will find its own path and most likely the one of least resistance. There is no guarantee that this path will take it back to the stock market whatsoever.
In short, there is a lot of uncertainty around this new policy of the US central bank. Scaling back its quantitative easing program could stop the flow of money to the stock market, potentially with a huge correction as a consequence. On the other hand, if the Fed keeps writing checks, it risks inflation getting out of hand in the long term, which would also be bad news for the stock market. The most sustainable scenario for stocks – a correction followed by a new breakout – seems likewise to be running into more and more challenges. That is why we will remain cautious around the stock market over the coming months. The only thing that would truly convince us now is a powerful breakout to the upside on all levels. Potentially, Janet Yellen could still deliver that, but until that time, cash is king.
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