Fed Tapering Comments Expose Stock Market Rally Weakness

by: Daniel R Moore

Nothing surprises me in the stock market (NYSEARCA:SPY) (NYSEARCA:DIA) these days. Another week and stocks are up another 1%-17% so far this year. But there must be something surprising in the data that investors need to know. Some intriguing nugget of information that will satisfy the thirst for understanding just why the stock market is levitating like a Maglev train that can reach speeds of up to 300 mph while bog standard technology has passengers cruising from D.C. to New York at a snail's pace. Maybe the financial markets have just entered a gravitational weightlessness zone where the laws of financial physics no longer apply. Warren Buffet often comments that the Fed supplies the gravity. Lately I think he must mean anti-gravity.

What is driving the U.S. equities so much higher at this time in the face of slow growth prospects? And, why has the market churned higher over the past month even as the interest rates moved higher? This would be a great sign for the economy if it could be sustained. It might actually mean that the Fed can exit its stimulus program without the stock market imploding.

These are questions that in light of the change in direction of market interest rates are worth analyzing further.

Stocks and Bonds in Lock Step Inverse Correlation From January 2009-April 2013

In my previous articles, I have been critical of the Fed on many counts. The zero interest rate policy is an indirect tax on savers in the U.S. to lower the cost of borrowing by the U.S. Treasury. In turn the money is redistributed to corporate bailouts and other specially selected groups who are more than happy to oblige by taking the cash. But the one aspect of Fed policy that investors have witnessed across the board is a dramatic rise in traded investment asset prices. The graphic below summarizes market performance relative to what the Federal Reserve influences most directly, interest rates, over the last four years and four months:

Click to enlarge images.

The inverse correlation between stock and bond prices and interest rates, and the Fed's prolonged policy of keeping rates low for an extended period has created a market in which everybody is now a market genius. Anyone who owns a stock portfolio, bond portfolio, or just about any portfolio which is priced relative to the interest rate market has seen the value of their investments rise since early 2009.

Something Changed -- Correlation Broken in Mid-April

The chart below shows the trading pattern of interest rates and stock markets since mid-April:

Historically, the Fed is not an oracle that magically places (or takes away) money in your investment account. There are real economic factors that should be influencing price levels. And, some of those variables may have re-entered the market valuation space in the middle of April.

I published an article in early April -- "Will Japan Create Inflation Or Just Export Deflation?" -- discussing the impact that the Bank of Japan's monetary actions would have on the U.S. Essentially the BOJ set a marker in place that it was not going to sit by idly and watch their export economy suffer as QE weakened the USD. The yen has subsequently weakened to over 103 USD/JPY. In his testimony on Capitol Hill on May 22, 2013, Bernanke remains publicly optimistic that Japan's policy will affect its domestic economy and benefit its trading partners. I remain skeptical, partly because his statement went on to point out that the relative to the size of the Japanese economy, the BOJ stimulus plan is three times the size of the U.S. My question is why wouldn't they just implement a large scale fiscal policy and monetize it if their intent was to create domestic demand and inflation?

Since my article, U.S. Treasury Secretary Jack Lew made headlines on May 10 with the following statement:

'The world community has made clear that domestic tools that are designed to deal with domestic growth are within the bounds of what the international community thinks is appropriate,' he said. 'But policies that are targeted to affect exchange rates are not. As long as they [Japan] stay within the bounds of those international agreements, I think growth is an important priority. We've made it clear we'll keep an eye on that.'

This is more in line with my previous article. The Japanese policy is designed to be a direct response to the affects of the U.S. Fed QE. The "keep an eye on that" statement means that excessive buying of U.S. Treasuries are currently out of bounds. The virtual take-over of the government MBS security market by the Fed has made the GMBS market untouchable for the Japanese monetary stimulus to affect exchange rates. These two markets have been favorite, risk free havens for the Japanese carry trade. But the capital inflows into the U.S. can take other forms, and the next best market is the highly liquid U.S. equity market. This most likely explains the rapid rise in the equity market since mid-April, in contrast to the actual economic results and prospects for the U.S. economy at the present time.

Why Are Rates Moving Up?

The Fed's balance sheet continued to expand in the past month. This should have produced continued downward pressure on the term structure of interest rates. However, this is not what happened. There are two market affecting events that I have observed. One is the news that the Fed is discussing the tapering of QE purchases. This explains more recent moves up in rates. But the rate pattern started earlier in time.

Looking at the data over the past 30 days, there is one variable in the Fed holdings that changed direction and is correlated to the interest rate move -- Central Bank Liquidity Swaps. Central Bank Liquidity SWAPs are temporary reciprocal currency arrangements to provide certain foreign central banks liquidity in U.S. dollars to facilitate dollar based transactions in overseas markets.

During this time period, dating back to earlier in the year, the SWAP account on the Fed balance sheet was elevated (whereas it had been reducing over time since the 2008 financial crisis). In mid-April, when Germany approved the bailout package for Cyprus, the account decreased. It briefly went up in early May, possibly due to continued Cypriot unrest. However, as the first installment of the bail-out was transferred on May 14, the SWAP line continues to decline. These market events correlate closely with the interest rate trading pattern.

In absolute terms, the $8B size of the SWAP line seems inconsequential to the $3T Fed balance sheet and the almost $12T publicly traded Treasury market. However, it appears to be highly correlated to capital flows into and out of the U.S. Treasury market by Europe. The resolution of the Cyprus crisis, and whatever it foretells about how future crisis's will be dealt with, has translated into lower demand for U.S. Treasuries, particularly longer dated paper -- two years and beyond.

This movement up in the rate term structure tells me the European market is selling Treasuries and taking the capital back to play in their own sandbox.

The other market driver of the interest rate trade is the market data point from the Fed minutes and testimony that show the Fed discussed an actual June 2013 tapering of QE, well ahead of the end of year 2013, end of the program schedule. This brings the current deceleration in Fed purchases into focus, and the market players that want to get out in front of the move are pricing in expectations for a change.

Portfolio Strategy and Asset Allocation

What had been a steady diet of higher bond prices (NYSEARCA:AGG) (NYSEARCA:BND) (NYSEARCA:SCHZ) and higher stock prices (NYSEARCA:IVV) (LAG) (NYSEARCA:VOO) is now a market with accelerated up moves in stocks and a reversal in interest rates. The inverse correlation has been broken, but for how long? Will selling continue in the bond market while equity prices continue to rise? Not likely.

The value of stocks and bonds is being derived from fund flows and positions which are being dictated by central bank policies, not fundamentals. The affect of these policies is actually the inverse of the real economy. In other words, when things do get better, the Fed will do the opposite of what they are doing today. Ironically, the medicine central bankers are administering today is causing a double digit run-up in equity asset values and the economy is in bad shape. Taken to the logical conclusion, when things are really good, expect double digit declines in your equity portfolio -- unless the real economy can take over.

Don't chase a market that is up 17% this year that has no economic underpinnings. What went up so far, and so long together is currently going to trade down together. This will remain the case until the fundamentals are in place to break the correlation. I will provide detailed data to back this position up in my next article. For now, selling in May and going away seems to be the best strategy at the present time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.