The reaction to the Fed statement spoke volumes about what we might expect from investment markets in the coming months. A look at the immediate reaction following the Fed’s announcement from four broad asset classes essentially tells the entire story.
Stock investors seemed to finally start waking up to the fact today that the Fed’s strategy going forward is NOT focused on inflating the stock market. This fact should not have come as a surprise for several reasons.
First, past efforts to inflate asset prices have proved futile in sustaining economic growth. QE1 was initiated to save the global financial system and resulted in inflated asset prices, while QE2 was launched explicitly to inflate asset prices and create a wealth effect, and neither succeeded in achieving a persistent recovery. Thus, the Fed would be misguided in returning to this option once again this time around.
Second, balance sheet expansion by the Fed is the key in trying to inflate the stock market, and nothing in the Fed’s comments from the last several months have even suggested that they were considering expanding the balance sheet any further than they already have.
Third, the Fed is under increasingly wilting political pressure. Criticism has been mounting on the Fed for some time that their policy actions have not succeeded in generating an economic recovery and are instead undermining the integrity of the U.S. dollar. The latest was a letter sent by GOP leadership to the Fed asking that it abstain from further stimulus actions. The Fed does not want to compromise its independence with its policy actions. And given the possibility that Republicans could take control of the White House and the Senate in 2012, the Fed recognizes that it must act prudently to avoid any further political threat. Thus, it is likely that we will need to see extreme conditions before the Fed is willing to expand its balance sheet any further.
Lastly, the Fed needs to maintain some policy flexibility in the event of a crisis. The situation in Europe remains tenuous. As a result, the Fed needs to hold back its remaining policy resources so that it can intervene with stimulus in a more constructive way in the event that a contagion begins to unfold in global markets over the coming months.
Stocks must now stand on their own and rely on fundamentals to move from here. They can no longer rely on stimulus from the Fed to get another artificial run higher. Global economic and market conditions would likely need to deteriorate materially from here before the Fed would begin to even entertain QE3, but such an outcome implies far lower prices for stocks than where we are right now.
The Fed’s strategy going forward is explicitly focused on the bond market. It tried two times with stocks to get the economy going and didn’t work, so now it’s going to try with bonds. The priority for the Fed is to lower borrowing costs even further to stimulate activity in the credit markets.
It has already been a tremendous year for U.S. government bonds including the iShares Barclays 20+ Year Treasury Bond ETF (TLT) shown above, but the potential for further upside still exists, particularly in selected bond market segments. I will be expanding on this idea further in two upcoming articles.
The Fed announcement today was bullish for the U.S. dollar (UUP). If the Fed is truly moving down a path of greater monetary prudence and is reluctant to further expand its balance sheet, and the U.S. government is actually able to make accomplishments in deficit reduction and addressing the debt issue, these are themes that are supportive of a stronger U.S. dollar. Today’s price action suggests that some belief in these notions may now be starting to seep into investment markets.
I have been bullish on Gold (GLD) for years. My primary thesis for owning the yellow metal has been global currency debasement and competitive devaluation and the persistent threat of financial contagion. However, today’s action by the Fed has provided a reason to reevaluate this thesis for the first time in years. If the Fed and the U.S. government were truly shifting toward greater policy constraint, the resulting strength in the U.S. dollar would begin to weaken the potential for further upside in Gold. The response in the Gold price following today’s Fed meeting suggested as much. With this being said, the threat of a global financial contagion is still meaningful, and global policy is still biased toward currency debasement. But at a minimum, existing positions in Gold merit evaluation for potential hedging strategies. I will be revisiting this topic in an upcoming article.
Bottom Line – If it wasn’t clear before, it should be clear coming out of today. The Fed is not focusing on the stock market with future policy actions. Instead, it’s focusing on the bond market. And the fact that the Fed may be starting to show monetary constraint and the U.S. government is showing signs of following through on getting its fiscal house in order is positive for the U.S. dollar but may require applying some hedges to existing Gold positions. Of course, the threat of another global financial crisis looms large in Europe, which may force a change in Fed policy before it's said and done. But stock prices would likely be far lower than current levels before any rumblings of QE3 would start to come from the Fed.
This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.