Market's 'Hall Pass' Is Gone: "Bad News Is No Longer Good News"

It has seemed that the Fed's liquidity back stop has provided excuse after excuse for whatever macro-, micro-, or event-risk driven problems that market has faced. But now, as Morgan Stanley's Adam Parker notes, the big outcome from the earlier-than-expected start of tapering is that going forward, "bad economic news will be bad for markets." The market knows and most Fed governors know there are diminishing returns to QE’s efficacy, and we have shown it here. So, something new and massive would be required in order for poor economic news - should it surface - to be rewarded the way it has been for much of the past year."  What is more concerning to Parker is that diminishing returns to the existing QE are already an implicit form of tapering and if the Fed wanted to maintain its impact on the market, it would have to expand QE - i.e. Fed tapering already underway.

 

Via Morgan Stanley's Adam Parker,

We think the Fed is aware of the diminishing returns to QE, and in the face of stabilizing economic data, this led them to signal that they would begin to withdraw from the program. We have been saying for some time that “good economic news is good for markets and bad economic news is good for markets” or that the market had a “Hall Pass” until July. Well, we think the Hall Pass is over and that this regime changed last week. The big outcome from the earlier-than-expected start of tapering is that going forward, bad economic news will be bad for markets.

The market knows and most Fed governors know there are diminishing returns to QE’s efficacy. So, something new and massive would be required in order for poor economic news – should it surface – to be rewarded the way it has been for much of the past year. On the flip side, we don’t think we will remain in a prolonged environment where good news is punished. After all, the market has already become anticipatory of the coming tapering and ultimately the tightening a couple of years down the road.

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The early response of the S&P 500 to QE showed a positive and significant correlation to weekly balance sheet changes. While no longer significant, this correlation remained positive until April 17, 2013. Recent correlations have been negative to flat.

 

This situation – a strong initial response, followed by weaker subsequent impact – is reminiscent of the diminishing returns we observed late in QE2. Perhaps even without tapering, the current program may soon be inadequate to further influence equity markets.

We think the Fed knows this, and hence, 2 months later, had to signal that they would begin to withdraw from the program. We have been saying for some time that “good economic news is good for markets and bad economic news is good for markets” and that this regime will change.

We think last week was a big deal, because now bad economic news will be bad for markets. The market knows and most Fed governors know there are diminishing returns to QE’s efficacy, and we have shown it here.

So, something new and massive would be required in order for poor economic news, if it surfaces, to be rewarded the way it has been for much of the past year.

Diminishing returns to the existing QE program complicate evaluation of the impact of tapering on equity market performance. Said differently, diminishing returns are already a form of Fed tapering, and the Fed should actually be expanding its QE if it wanted to maintain its impact on equity markets.

From the standpoint of the S&P, Fed tapering is already underway.