Wednesday, the Federal Reserve will decide whether or not to cut back on their long-lasting quantitative easing policy. What does this mean and why should you care? This could drastically affect the low interest rate cycle that the equity market has been built upon since the end of the Great Recession, which basically marked its lows in the spring of 2009. So, could this be the top for the stock market? After a four-year bull market, changes in everyday interest rates, including many types of loans, have risen substantially. While consumers are already feeling the pain in items such as mortgages, the stock market has largely taken this move in stride and is closing in on its 2013 highs as of this week. Also important, this also changes the cost of capital for businesses around the world.
While the Fed is not officially changing their stance on interest rates, a cut back in the amount of bonds the Fed buys each month will essentially mark a change in policy. This new policy may change the landscape and here's why: When longer-term interest rates begin to rise, this can make yields on certain bonds become more attractive. Since US Treasury Bonds are inherently less risky than stocks, and because the US government has a very low risk of default, this at least makes certain investors consider bonds as opposed to a riskier agenda of stocks. For the last four years, the choice was easy. With short-term bonds essentially yielding nothing, and the risk of the financial collapse falling further and further into the past, many stocks had higher yields than bonds. Plus, investors had the upside of price appreciation with a stock. Now though, with stocks more than doubling from their lows, there are few people that would tell you that they are the bargains that they were during the panic. In an ultra-low interest rate environment, the choice was pretty easy. Now, the market becomes more complex.
There is a further risk that the Fed created certain asset bubbles due to these low rates and we will only find out what skeletons are in the closet, once rates move up. This is the so-called, Black Swan effect, made popular by Nicholas Nassim Taleb in his best-selling book of the same title. Essentially, this phenomenon happens when no one expects it, and it occurs often in an emotion-driven vacuum like the stock market. Just because it's never happened before, doesn't mean it can't, as we saw in the real estate collapse. A possible spot for this could be the bond market. Naturally, as stocks collapsed during the panic, a natural, safe landing spot for capital was the bond market. Now, longer-term bonds are falling apart as interest rates rise. Investors piled into bonds by the masses and now are feeling the effects. Another concern is emerging markets and the foreign exchange markets associated with them. As the Fed becomes more hawkish and capital is treated better here in the US, there have been massive outflows of capital from places like India and this has many worried. While I am not calling an end to the bull market quite yet, investors should at least start to become more wary. The ground under our feet is beginning to shift. These are the types of issues we examine at Financial Advisor Austin Wealth Management. For more information, visit our site.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.