The Fed, QE and stock markets

Hints of Fed chairman Ben Bernanke that the FOMC might decide in one of the next few meetings on modifications of the bond buying program stopped the rally at the US stock market. During the first five month of this year, institutional investors reduced their holdings in the SPDR Gold Trust ETF to invest proceeds in the stock market. Therefore, if the US stock market will become less attractive and enters into a correction, then also the outflows of gold ETFs might came to an end.

We have developed a series of quantitative models for various major stock markets, which are all based on the macroeconomic portfolio theory. This theory is based mainly on the contributions of James Tobin, who became known to a broader public outside the economic academic world due to his proposal to reduce speculation in foreign exchange markets by imposing a tax. The demand for an asset increases with rising wealth and income of an economy. Furthermore, demand will be higher if the rate of return of an asset increases, but higher returns of alternative assets reduce the demand.

In the quantitative model, we focused on macroeconomic variables with a monthly frequency. Therefore, we used some variables, which are closely related with the development of GDP, which is widely used to represent the income of an economy. For the monetary policy impulse, concepts of money stock aggregates could be used. However, better results were obtained for many countries by using interest rates instead. For the S&P 500 index, the yield on 2- and 10yr US Treasury notes entered the model, while for some other indices the spread between the yields for these two maturities of the corresponding government bonds yielded better results. The indicator is constructed as an oscillator to model the yoy percentage change of a stock index, therefore, also the yoy-change of the interest rates are used as explanatory variables in the quantitative model.

To analyze the impact of scaling down the bond purchases by the Fed, we have to analyze, which impact would a gradual reduction of QE have on US Treasury yields for the two maturities. At the short end, the upside potential appears as rather limited for two reasons. First, the purchases in the US Treasury market by the Fed were concentrated on medium- to long-term maturities. Thus, scaling back the volume of purchases by the Fed would not have a direct demand impact on the 2yr US T-notes. Second, the Fed indicated that the extremely low level of interest rates would prevail well into 2015. Thus, the Fed Funds target rate remains at below 0.25% for quite some time and this should be reflected also in the yield on the 2yr US T-Notes. Thus, the most likely case appears to be that the short end of the US Treasury curve does neither provide a stimulus nor a burden for the further development of the US equity market.

A stronger risk for stocks could come from the longer end of the US Treasury market. If the FOMC decides to reduce the volume of monthly bond purchases, the usual c. p. argument is of course that this would lead to lower demand and thus rising yields. However, one has to take also the supply into account. Furthermore, at a higher yield level, institutional investors might increase their demand and thus, compensate the shortfall of demand from the Fed. But one has to keep in mind that the US Treasury market already reacted and the yield on 10yr US T-notes rose in May 50bp from the low of the month. This was the major negative factor for the macroeconomic indicator in May. Last year, the low in the yield on 10yr US T-notes was during the months of May and July, during the rest of the year, yields were higher. Thus, the basis effect should also provide a buffer after July.

Currently, our macroeconomic indicator for the US stock market is still signaling a positive economic environment for the stock market despite the drop in May. Only a decline below a moving average line would indicate that the fundamentals turned negative for stocks. A further rise of 10yr T-note yields to around 2.5% over the next two month could have a negative impact and might be the trigger for a bearish crossing of the indicator and its average line. A gradual increase to 2.5% by year end would have a less severe impact on the indicator. However, even if the macroeconomic indicator turns negative, it is not an immediate reason to become bearish on stocks. A further condition would have to be fulfilled to trigger a sell signal for the S&P 500 index. Thus, gold and silver bulls better don’t bet that a possible FOMC decision to reduce bond purchases would lead to a major correction of the US stock market and would drive investors back into the precious metals markets.