Since the 2008 financial crisis, the FED has been pumping money into the economic system by buying $85B in bonds. This is what is referred to as quantitative easing. The idea behind quantitative easing is that banks will take this money and loan it to individual and businesses, which will increase jobs and stimulate the economy. The reality is that the FED can give banks money but they cannot force banks to loan that money.
There are a number of impacts associated with quantitative easing that explain the reaction the market is having to FED policy.
First, when the FED decreases the supply of bonds in the market by buying $85B in bonds, this increases demand for bond, which then increases the price of bonds. While some investors look to the bond market as a form of hedge, other are in search of a regular income stream in the form of coupon payments, while many are speculators. The speculator trades on the price of the bond. If the speculator believes the bond price will go up, he/she will buy the bond with the goal of buying low and selling high. Therefore as the FED has continued to buy bonds, bond market speculators continue to buy bonds. And so we have a bull bond market since 2008. If the FED tapers we may be headed for a bear bull market.
Second, high bond prices means low yields. Investors seeking higher yield have turned to stocks. The stock markets continue to climb as the FED continues with quantitative easing. This leads to a number of concerns. Are stocks appropriately valued based on company fundamental or are the values artificially inflated due to FED policy. Many of the earnings reports from last quarter have been less then stellar with firms meeting low analyst expectation by focusing on the cost cutting rather than top line. If the FED tapers the equity markets are likely to suffer.
Third, the low yields associated with FED policy have also made debt financing incredible appealing to U.S. companies. The FED hopes companies will use bond proceeds to reinvest in their firm in a way that will ultimately increase jobs. However, not all firms are doing so. Some are using the proceeds to buy company shares, thereby increasing their EPS ratio without increasing earnings. Still other are using the proceeds to pay dividends to shareholders. If the FED tapers, this will certainly put an end to the rush to debt financing.
Finally, FED policy also has an impact on currency and commodities. Investors want to hold currency with high interest rates. With interest rates at an all time low, few investors care to hold the dollar. Gold, often viewed as a hedge for inflation, has been gradually increasing since 2008. If the FED tapers, the value of the dollar is likely to increase while the price of gold is likely to decrease.
Given all the impacts, it is not surprising that investor hold their breath as FED chair Ben Bernanke takes the stage to speak. Every sentence is dissected in an effort to determine when to get out of one trade/market and into another. A flip flopping FED decisions certainly do not help the situation. It appears that FED transparency is quickly becoming a double-edged sword.