Reacting To The Fed Minutes: Will The Market Get Fooled Again?

Includes: GLD, SPY, TLT
by: Eric Parnell, CFA

The U.S. Federal Reserve released the minutes from their latest meeting on Tuesday. And the reaction was most interesting to say the least, as it seems that the market may be setting itself up to be fooled once again.

So what exactly was the message from the Fed? In short, they see no need to initiate additional stimulus programs unless the economy slows. Quelle surprise.

First, the fact that the market reacted at all to the Fed minutes was notable in its own right. After reviewing the minutes several times Tuesday afternoon, little if anything was surprising or unexpected in its contents. That investors were compelled to react on Fed commentary with which they should already have been more than comfortably familiar highlights once again the apparent lack of discipline underlying the current market.

But exactly how the market reacted to the Fed minutes was even more interesting. Stocks (SPY) sold off, but clawed their way back to pre-Fed minute levels by the close. Gold (GLD) initially fell like a stone and then flat lined for the rest of the day. And U.S. Treasuries, after trading higher for the day leading up to the release of the Fed minutes, immediately plunged lower and then continued sliding for the remainder of the day. The damage in the Treasury market was most pronounced among Long-Term U.S. Treasuries (TLT). An interesting response indeed.

It seems that the market is setting itself up to get fooled once again. A general market perception as we approached the end of both QE1 and QE2 was that the bond market would sell off dramatically once it lost the Fed as a major buyer of these securities, but the stock market could continue to rise behind an economy that was strong enough to support asset prices on its own. And as we approach the end of Operation Twist in June 2012, it seems at least based on today's trading response to the Fed minutes that the market holds the same beliefs once again.

Here's the thing. Stocks LOVE Fed stimulus. Over the last three plus years, they have shown that they simply can't live without it. U.S. Treasuries, on the other hand, HATE Fed stimulus. Want to kill a healthy Treasury rally? Have the Fed launch a new stimulus program. As for gold, it typically doesn't care if the Fed is stimulating or not, as it is more dependent on prolonged currency debasement and the persistent threat of global crisis. The following data below highlights this point:


March 2009 to March 2010

Stocks : +72.86%

Gold : +20.29%

U.S. Treasuries : -10.83%


April 2010 to August 2010

Stocks : -10.45%

Gold : +11.02%

U.S. Treasuries : +23.20%


September 2010 to June 2011

Stocks : +26.11%

Gold : +20.70%

U.S. Treasuries : -10.06%


July 2011 to September 2011

Stocks : -16.77%

Gold : +10.25%

U.S. Treasuries : +33.19%


October 2011 to Present

Stocks : +28.58%

Gold : -0.66%

U.S. Treasuries : -9.29%

Once again, as evidenced by the data above, stocks LOVE Fed stimulus, Treasuries HATE Fed stimulus, and gold generally does not care.

But how again did the market react Tuesday to the idea that the Fed may not apply additional stimulus once Operation Twist, which is a stealth QE3 program, comes to an end? Stocks sold off initially then recovered, while Treasuries got pummeled. Go figure.

The reasons cited for the Treasury sell off were the same we heard toward the end of both QE1 and QE2. Without the Fed, who is going to buy U.S. Treasuries? Here's who.

Sure, the Fed has bought a lot of Treasuries over the last several months. And they'll have bought $400 billion worth by the time we reach the end of June. But when the Fed is stimulating, it provides a window of time where investors feel comfortable taking on additional risk. This implies the opportunity to favor stocks over Treasuries in security selection.

When the Fed completed its previous stimulus program in QE2 back in June 2011, the total U.S. stock market capitalization was $17.858 trillion according to the World Federation of Exchanges. But by the time the stock market endured a few months standing naked without stimulus by the end of September 2011, this market capitalization had declined to $14.045 trillion. This represented a market cap decline of $3.8 trillion over the course of three months. This money leaving the stock market in duress had to travel somewhere, and a good portion of it fled to the relative safety of the U.S. Treasury market. It should be noted that $3.8 trillion is more than six times the size of the $600 billion Treasury purchase program behind QE2.

Since the launch of Operation Twist, U.S. stock market capitalization has returned to $17.781 trillion. Once again, this represents a $3.7 trillion increase since last October and is more than nine times the size of the Fed's current $400 billion Treasury purchase program. If capital needs to flee the stock market once again and move to safety, more than enough money would be flowing into U.S. Treasuries to make up for the loss of the Fed as a buyer. And it's not as though the Fed will be a major seller of its U.S. Treasury inventory either, which may only serve to provide additional upside pressure to Treasury prices under this scenario.

For all of these reasons, Tuesday's market response to the Fed minutes may be presenting an opportunity. This includes the potential to lighten up on selected stock positions that may be facing increasing pressure in the coming months if the Fed sticks to its word about no further stimulus. Even if they hold off on applying additional stimulus for a few months, the market response could be severe to the downside particularly at currently elevated levels. On the flip side, an increasingly attractive buying opportunity may be developing in the U.S. Treasury market. As for gold, patience should continue to be rewarded in the long-term, even if recent volatility continues to frustrate.

If it turns out that the market is setting itself up to get fooled yet again as we move toward the end of the latest Fed stimulus program, it may be worthwhile to stand ready to capitalize.

Disclosure: I am long GLD, TLT.

Disclaimer: 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.