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I hadn't been watching things very closely the last few days, and so I was shaken to see the market drop amid concerns that the Fed was likely to end its current Quantitative Easing program. But after looking at market fundamentals, I'm reassured that this is nothing more than a "little wall of worry" in the market's long climb to new highs.

If the Fed was going to accelerate its tightening timetable, then that should be reflected in a significant rise in two-year Treasury yields. The yield on two-year Treasuries is driven primarily by the market's guess as to what overnight rates will average for the next two years. Yet those yields have not budged on average for the past six months, and in the past few days they have even dropped a few basis points. Swap spreads are still very low and have not budged at all. So the bond market is not worried about a tighter Fed. The only sign of concern is the VIX index, which has jumped from 12 to 15, but that's not telling us anything about the economy, only about how worried investors are.

And even if the Fed was to begin raising rates sooner than expected, that is hardly a reason to worry. It's more logical to think that would be a good thing, since the Fed's current ultra-accommodative policy stance has created mountains of uncertainty about the future value of the dollar and inflation. Short-term rates of 1%, 2%, or even 3% wouldn't pose a problem at all to the economy if it were a bit stronger than it is today, and there is almost no chance the Fed would raise rates if the economy were truly headed for a fall.

In the meantime, all the Fed is doing with its QE program is swapping bank reserves for bonds. It's not printing money, and it's not directly sustaining the equity market. Banks already have way more than enough reserves to support massive increases in lending. Financial market liquidity wouldn't begin to be adversely impacted until the Fed started aggressively draining reserves, and that won't happen for a long time.

What is sustaining the equity market is the realization that the economy is not doing as badly as had been expected. It's still growing, albeit slowly. The yields on non-Treasury securities are very attractive as long as the economy doesn't sink into another recession, and there is no sign of that about to happen.

Source: Climbing Little Walls Of Worry