These days there are few things one can know for certain, especially when it comes to digesting the intricate rhetoric of Federal Reserve officials. Will the Fed's monetary policy be ratcheted down at the next Federal Open Markets Committee (FOMC) meeting? Or will QE3 asset purchases be gradually reduced starting in 2014? It is essential for all investors to recognize the future movements of the most important fundamental driver of US equity markets: the Fed's monetary policy. For starters, let's go over what we do know for certain.
The Indications Are In The Statements:
Following each FOMC meeting, there is a short one-page media release highlighting important decisions the Fed has made during the meeting. This is open to anyone right on the Federal Reserve's website. I find this the most important of all the Fed's talk because it is collective, transparent, and often alludes to future policy moves down the road. The Fed reveals a specific criteria in which asset purchases will be tapered in its May statement affirming that:
"this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal."
They also add one other key point by pledging to:
"closely monitor incoming information on economic and financial developments in coming months".
These are the three major goals the Fed is looking to achieve in order to peel back QE3: improvement in economic data, inflation, and the labor market.
Pillar #1: Inflation:
2% is the magic number when it comes to inflation. This is the target the Fed believes is significant because past this point, quantitative easing may generate unwelcome inflationary effects on the US economy. Inflation rang in at 1.1% according to the May 16 Consumer Price Index (CPI). This is well beneath the 2% goal and demonstrates the lack of inflationary pressure being exerted by the Federal Reserve's massive asset purchases. Historically, our current inflation is also very low as illustrated below.
Pillar #2: The Labor Market:
Last Friday the May jobs report came in marginally above expectations at 175,000 jobs added vs. 167,000 expected. However, the unemployment rate clocked in at 7.6% rather than the expected 7.5%. The reaction to this data was decisive. The markets tipped their hand as the Dow Jones Industrial Average rallied over 200 points. One can conclude from this rally that this jobs number was neither too good nor too bad. It was just right. It was good enough to be in line with the Fed's views of "moderate growth", but not good enough to move the unemployment rate needle to 7.5%. Still more than 1% over the Fed's unemployment target, there is still much room for improvement. In addition, average hourly earnings (m/m) for May did not budge (expected 0.2% increase). Once again, the unemployment rate remains historically high as we fail to add north of 200,000 jobs each month.
Pillar #3: Recent Economic Data:
As you can see, the past few weeks' key economic data has been lackluster and inconsistent. The impressive initial CB Consumer Confidence number can be attributed to a wealth effect, which has been generated lately by the rallies in US equity markets. Still, this data does not represent the consistent success that could sway the other taper-opposing six FOMC members to alter their stances.
After evaluating each pillar, I think it is evident that each key topic is not yet at a point in time in which FOMC members will be swayed to taper the monthly $40-45 billion asset purchases of quantitative easing. I think this is very bullish near-term for the three major US indexes after sustaining a mild 3-4% correction last week and rallying back. I think it is especially interesting to note that the S&P 500 held the psychologically and technically important 1600 level. I believe that the Federal Reserve will taper its purchases in January 2014 at the earliest. I also am interested in staying in this market until year-end as I ride the continuing effects of QE3 to new highs and further profits. The views in this article can be expressed through buying the major index ETFs (QQQ, SPY, DIA) or a sector SPDR of your choice. Below is a final chart illustrating the correlation between past quantitative easing and the stock market.
Note: the increase in reserves is a direct representation of the past and present quantitative easing.