A Major Market Turning Point May Be Struck Next Week

by: Eric Parnell, CFA

The U.S. Federal Reserve has been recently signaling that they may be preparing to scale back on their QE3 stimulus program in the coming months. Investors are understandably keeping a very close watch on such developments from the Fed, for these balance sheet expanding monetary stimulus programs have provided a great deal of support for rising stock prices over the last several years. While much of the focus to this point has been on exactly when the Fed may begin tapering their asset purchase program, the more important question is exactly how they plan on cutting back on asset purchases. Not only will this have a far greater impact on the direction of stock prices going forward, but it may strike a major turning point in the stock market as soon as next week.

The question of when the Fed plans on tapering its QE3 program is centered primarily on three scenarios. Some are predicting that the Fed may begin tapering as early as its next FOMC meeting in June. Such an outcome is unlikely, however, given that the Fed is hypersensitive to the market reaction on any tapering announcement and would likely prefer to try and ease investors into the idea that such a change is coming. As a result, many are projecting instead that the Fed may effectively announce following its June meeting its intention to begin tapering at its next two-day FOMC meeting in September. This is the more likely scenario, as it provides markets with three full months to digest this announcement while also providing the Fed the flexibility to delay if economic conditions deteriorate or the market has a severely adverse reaction. The third scenario is that the Fed plans on staying the course and will not announce its intentions to taper anytime soon. But given the recent comments coming out of current and former Fed Chairmen and other Fed officials, it seems that their talk of tapering is far more than just trying to jawbone stocks lower at this point. And given the recent signs of instability in a variety of global market segments since the launch of Japan's ultra aggressive monetary easing program, it is likely that the Fed sees some prudence in taking some of their own juice off of the table at this point.

Working under the assumption that the Fed will begin tapering in September if not earlier, the next question is exactly how might they plan on carrying this out. And it is on this point that will have the most profound impact on financial markets in the end.

The composition of the Fed's QE3 program is as follows. The U.S. Federal Reserve is currently purchasing assets totaling $85 billion each month. This effectively amounts to the Fed providing the funding for a new $3.9 billion institutional asset management firm each and every trading day on average. But all of this money is not necessarily injected into the financial system each trading day. And this point alone has critical importance for how the Fed moves ahead with any tapering plan going forward.

QE3 can be broken down into two primary components. The first is the purchase of $40 billion in mortgage-backed securities (MBS) each month as part of a program that began on September 14, 2012. The second is the purchase of $45 billion in U.S. Treasuries each month as part of a program that began on January 3, 2013. This distinction is particularly important, for the flow of liquidity into the financial system is vastly different from these two programs.

The U.S. Treasury purchase program is the more straightforward of the two programs. The Fed releases a calendar each month tentatively detailing how it plans on carrying out its $45 billion of asset purchases for the month. The daily purchase amounts range from $0.75 billion to $5.75 billion. The Fed executes these purchases between 10:15AM and 11:00AM on a given trading day. And perhaps most importantly, these trades settle the next trading day. Thus, the U.S. Treasury purchase program represents a steady and instant liquidity injection into the financial system.

The MBS purchase program is a bit more complex. The Fed also makes daily purchases of MBS securities as part of its $40 billion monthly outright purchase program. But when the Fed purchases these securities, the cash does not change hands right away. This is due to the fact that MBS securities do not settle immediately like U.S. Treasuries. Instead, it can take several weeks if not a few months before these MBS purchases finally settle. And as for the settlement dates, they are concentrated on three specific days each month. Using the month of June as an example, the first major MBS settlement block will occur this Thursday, June 13 for 30-Year Term Fannie Mae and Freddie Mac securities totaling $23.4 billion followed by two smaller MBS settlement blocks on June 18 for 15-Year Term Fannie Mae and Freddie Mac securities totaling $7.0 billion and on June 20 for 30-Year Term Ginnie Mae securities totaling $10.1 billion. Thus, all of the liquidity from MBS purchases spurts into the system on three specific days. Otherwise, additional liquidity flows from the Fed's MBS purchases are dormant.

The differentiation between these two purchase programs has significant implications for financial markets, particularly stocks. For when the Fed is engaged in daily U.S. Treasury purchases, stocks have shown the propensity to float endlessly higher. However, when the Fed is engaged solely in MBS purchases, the market has instead moved with much greater volatility and without much consistency to the upside.

A look at trading patterns in the S&P 500 Index (NYSEARCA:SPY) since these once extraordinary programs were first introduced in the aftermath of the financial crisis highlights this stark differentiation.

The following are the three price charts for the S&P 500 when the Fed was engaged in the outright purchases of U.S. Treasuries.

The first occurred during the period from March 18, 2009 to March 31, 2010 when the Fed purchased $300 billion in U.S. Treasuries. The market response was virtually straight up with very few and shallow pullbacks along the way, although it is notable that the trajectory of the advance increasingly faded the longer the program progressed.

The second took place during the period from November 12, 2010 to June 30, 2011 when the Fed purchased $600 billion in U.S. Treasuries. The initial market response was once again euphoric, although the rally eventually flattened out as the dampening effect in the later stages of the program was far more pronounced relative to QE1.

The third instance is currently playing out today, with Fed Treasury purchases commencing on June 3, 2013. But unlike QE1 and QE2, the Fed did not commit to an end date to its current Treasury purchase program. Once again, the initial response to the Fed's latest program has been ebullient with relatively few and shallow declines, although it is notable that the most pronounced pullback has taken place in the immediate aftermath of Chairman Bernanke's May 22 notice to Congress that tapering is currently under consideration and may take place in the coming months.

In summary, outright U.S. Treasury purchases by the Fed have shown the ability to lift stock prices dramatically, with the most profound impact occurring at the very beginning of the program and gradually fading over time.

In contrast, the following are the two price charts for the S&P 500 Index when the Fed was engaged solely in MBS purchases.

The first instance took place from November 25, 2008 up to March 18, 2009 when the Fed began purchasing $600 billion in MBS and Agency debt and before U.S. Treasury purchases were added. The stock market initially ground sideways in a choppy trading pattern with a modest downward slope for the first few months. Then came the bank stress test presentation by then Treasury Secretary Timothy Geithner on February 10, 2009. From there, stocks went on to plunge to their final early March lows. Overall, stocks took little cheer from the Fed's MBS purchases at the time.

The second instance occurred from September 13, 2012 to January 2, 2013 when the Fed began purchasing $40 billion in Agency MBS debt but before U.S. Treasury purchases were added. The stock market peaked for the year immediately following the announcement of the program and entered into a choppy trading pattern for the remainder of the year that also had a modest downward trend. While the uncertainty associated with the Presidential election and the fiscal cliff could be cited as potential reasons for the downside during these periods, it is not as though the market has not been presented with considerable risks thus far in 2013 that stocks have completely ignored to date.

All of this has important implications for stocks and financial markets under any tapering scenario for the following reasons. For when the Fed decides to scale back on asset purchases, it will need to decide whether to reduce the purchases of U.S. Treasuries, MBS or both. And it is this choice where the stock market may not like the outcome.

A priority for the Fed has been to support a recovery in the housing market. Part of achieving this objective has been working to lower mortgage rates. Thus, the Fed cannot be lost on the fact that the rate for a conventional 30-year fixed mortgage according to Bankrate.com had fallen from 3.68% just before the launch of their MBS purchase program in September 2012 to consistently in the 3.37% to 3.50% range once this program was revealed. The Fed must also not be lost on the fact that this same mortgage rate immediately jumped into the 3.55% to 3.75% range not long after U.S. Treasury purchases were added to the program in early 2013 and have recently spiked over 4.00% following a brief respite in April.

The Fed is left with a choice when tapering. They can either continue to try and generate a "wealth effect" that has proven elusive thus far in generating sustainable economic growth by maintaining U.S. Treasury purchases at the expense of forgoing their support of a housing market recovery and cutting back on MBS purchases. Or they can work to move mortgage rates back lower in support of the housing market by maintaining MBS purchases at the expense of giving up on some further gains in the stock market by cutting back on Treasury purchases. Focusing on recent comments from various Fed officials, particularly in regards to their concerns about monetary stimulus resulting in an increasing wealth disparity, along with growing concerns about the distorting impact on the housing market from institutional and affluent cash investors make it considerably more likely that the Fed will cut Treasury purchases first and keep MBS purchases in tact.

Thus, it would not at all be surprising to see the Fed announce in June its intent to begin tapering in September. A reasonable scenario would have the Fed keeping MBS purchases intact and reducing their U.S. Treasury purchases from $45 billion per month to the $20 billion to $25 billion per month range in September depending on how events unfold in the coming months, providing Fed officials with the flexibility to tweak the course between now and September if needed. The logical next step would have the Fed eliminating the remaining Treasury purchases by December, once again depending on how events unfold as much will take place between now and the end of the year. This way, the Fed could still maintain the market comforting claim that they are still providing $40 billion per month in asset purchases as part of their MBS program heading into 2014.

What does the idea of Fed tapering and the potential focus on scaling back Treasury purchases mean for investment markets? For stocks, it suggests that much of the gains for 2013 may have already been achieved at this point. Stocks as measured by the S&P 500 had already rallied by +18% for 2013 through their intraday peak on May 22, and virtually all of these gains have been achieved through multiple expansion, as revenue and earnings growth ground to a halt several quarters ago and earnings forecasts have been chronically revised lower for more than a year. And if QE3 behaves anything like QE1 and QE2, steady gains are likely to be increasingly replaced by a sideways chopping pattern now that a potential end may soon be in sight for the Treasury purchase side of its latest asset purchase program. Thus, lower volatility stocks as measured by the S&P 500 Low Volatility ETF (NYSEARCA:SPLV) that were outperforming earlier in the year may soon find renewed appeal, particularly following their recent -7% pullback to oversold levels and bounce off of support at its 100-day moving average. Utilities (NYSEARCA:XLU) may also provide interest following their recent -10% correction. A variety of high quality individual securities that also share these lower volatility characteristics along with reasonable valuations, attractive yields, favorable technicals and the ability to hold up better than the broader market during a correction may also be worth consideration including ExxonMobil (NYSE:XOM), International Business Machines (NYSE:IBM), General Electric (NYSE:GE), McDonald's (NYSE:MCD), Emerson Electric (NYSE:EMR), Qualcomm (NASDAQ:QCOM), Cisco Systems (NASDAQ:CSCO), Comcast (NASDAQ:CMCSA) and AT&T (NYSE:T). While all of the above ETFs and individual stocks represent ideal long-term holdings, each should be monitored closely in the context of the broader market environment, as action may be required in the event of a more pronounced stock market sell-off.

What about the impact on bonds? In what remains an ongoing misconception about QE, the removal of monetary stimulus is more likely to be far more beneficial than harmful to the high quality bond market, particularly U.S. Treasuries. This is because not all else is being held equal when the Fed decides to start and stops on Treasury purchases. Instead, market participants react in response to these Fed actions, and the net has been since the day these stimulus programs were first introduced that the rate of institutional capital flows into Treasuries seeking safety has more than offset the loss of demand when the Fed ends their purchase program and vice versa. In other words, recent history has indisputably shown that yields rise when the Fed is buying U.S. Treasuries as part of a QE program and fall when the Fed stops buying. Moreover, it is worth noting that the longer past QE programs have progressed, the more the downside pressure on the bond market has abated. Given how lofty and disconnected the U.S. stock market is today relative to nearly every other major global investment market, it is likely that we will see the same trend materialize this time around. Unless of course the Fed has lost complete control of the bond market, but the problems facing investors then will be much greater than just the asset allocation decision. Fortunately, this does not appear likely at present despite the recent move in yields. As a result, positions that are uncorrelated to negatively correlated to the stock market such as long-term U.S. Treasuries (NYSEARCA:TLT), Build America Bonds (NYSEARCA:BAB) and the PIMCO Total Return ETF (NYSEARCA:BOND) may actually soon see renewed vigor if it appears that Fed tapering may be imminent.

What about the precious metals such as gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV)? Won't any reduction in QE put additional downside pressure on these already downtrodden metals? The answer here is probably not after any immediate knee jerk reaction. Unlike stocks, a variety of forces other than just QE drive the prices of these precious metals. This point has been clearly demonstrated over the last several months. This has also been demonstrated by the ability of both gold and silver to rise smartly during periods in recent years after the Fed has ended QE programs and stocks are plunging. And if the potential winding down of the Fed's QE3 stimulus program sparks fresh fears among investors about potential instabilities in the global financial system, we may see investors that have contributed to the historically high net short positions in these metals at a minimum close out their short positions in dialing down their overall risk exposures. Such short covering may be prudent particularly given widespread evidence that already solid global physical demand has solidly increased following the recent price decline over the last several months and future supply may be more constrained than in the past. Thus, allocations to the Central GoldTrust (NYSEMKT:GTU) and the Central Fund of Canada (NYSEMKT:CEF) still have appeal from a portfolio diversification standpoint despite their recent challenges.

It will be interesting to see how events play out from here. The next key event to watch is the upcoming two-day FOMC meeting on June 18 and 19. Not only will any comments from Fed officials be worth monitoring in the days leading up to this next meeting, but the announcement following the meeting has the potential to set the course for investment markets for the remainder of the year. And this course may end up being decidedly different from the course we have seen to date in 2013.

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.

Disclosure: I am long CSCO, GE, T, XOM, MCD, CMCSA, IBM, QCOM, ORCL, EMR, SPLV, XLU, TLT, BAB, BOND, CEF, GTU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.