Here’s Why The Fed’s Stimulus and Stock Market Rally May Continue

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June 20, 2013 3:58pm NYSE:DIA NYSE:EEM

bearbull21-150x1501Mike Burnick: Stock-market volatility has spiked, bond-market selling is unprecedented, and investors have only one thing on their mind: When will the Federal Reserve scale back its $3.4 trillion stimulus program?

Slowing global economic growth and Japan’s latest foray into unconventional monetary easing are key concerns facing investors. But the biggest source of stress was on full display yesterday as Fed officials debated whether to taper their $85 billion-a-month bond-buying program. Although nothing much changed in the Fed’s official policy stance, as I expected, Chairman Ben Bernanke did his best to allay fears about an early end to its ultra-easy monetary policy.

But you can be sure that investors will soon again base their bets on the end of the four-year stimulus program that’s prompted stocks to more than double and drove bond yields to record lows.

Chairman Bernanke did his best to allay fears about an early end to the Fed’s ultraeasy monetary policy.

There has to be a better way to predict the direction of the markets. In fact, I’m closely tracking two potential red flags that may signal whether the decline in global stocks and bonds has run its course.

The Fed’s Closely Watched Indicator

The first is a measure of inflation expectations. A great deal of market volatility can be explained by uncertainty about the Fed’s intentions.

Until recently, investors didn’t expect the Fed to raise interest rates until sometime in 2015, at the earliest. But that was before Bernanke, speaking before Congress a month ago, suggested that if the central bank sees sustained economic improvement in the months ahead, policy makers “could take a step down in the pace of [bond] purchases.”

Thus, fears were born of an imminent end to quantitative easing. This tapering trauma was largely a self-inflected wound to market sentiment, pushing up a range of global interest rates on everything from government bonds and mortgage-backed securities to emerging-market debt, which took a beating.

That’s what prompted Bernanke to practice some damage control yesterday. But here’s why investors’ addiction to the central bank’s stimulus and ultra-low interest rates isn’t likely to be interrupted anytime soon.

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The graph above is the Fed’s favorite barometer of inflation expectations. It simply displays the difference between yields on benchmark 10-year Treasury bonds and 10-Year TIPS. As you can see, even with interest rates on the rise lately, inflation expectations have been falling all year, according to this market-based measure.

Remember, the Fed has a 2 percent inflation goal, in addition to its unemployment target. It doesn’t want inflation to rise too far above, or fall too much below, that number.

In fact, each time the Fed has launched or expanded another round of QE since 2008, inflation expectations were close to current levels and falling, just as they are today. Another inflation measure preferred by the Fed, the Personal Consumption Expenditures Index (PCE), is up just 0.7 percent, and the “core” PCE inflation rate, at 1.05 percent, is the lowest on record going back to 1959.

If the Fed thinks inflation is too low and that consumers and businesses expect this trend to continue, the central bank might see a new downward spiral in the economy as the biggest threat. As a result, it would likely continue the bond-buying program longer — and perhaps even add to it.

Rather than worrying about when the Fed will remove the punchbowl, its next move could be to spike it yet again. So keep a close eye on this gauge of inflation expectations. If it keeps dropping, it’s doubtful the Fed will be tapering its stimulus.

Emerging-Market Blowout

Another red flag waving on the horizon is the sharp underperformance in emerging-market stocks and bonds.

Click for larger version

The currency markets, especially the U.S. dollar and Japanese yen exchange rate, have grown in volatility. That’s because the dollar and yen have been the favored funding currencies to finance the global carry-trade for many years.

Thanks to pledges by the U.S. and Japanese central banks to hold interest rates near zero for a considerable time, the dollar and yen have become favorite targets for speculators to sell, using the proceeds to invest in other, higher-yielding currencies and asset classes.

A great deal of this carry-trade cash was invested in emerging-market stocks, bonds and currencies in recent years. But, lately, these carry-trades have been unwinding, sparking intense volatility throughout emerging markets.

As an example, the iShares MSCI Emerging Markets ETF (EEM) fell 2.6 percent last week and has lost 11 percent so far this year, while the MSCI World Index of developed nations is up 8.6 percent in 2013. The BRIC markets have been among the worst performers as investors pull money out of these faster-growing, but less liquid, markets.

Other emerging-market disasters include:

* Philippine stocks, up 25.9 percent over the past year, have fallen 11.1 percent so far in June.

* Brazil’s Bovespa stock index has plunged 7.8 percent this month, and Chinese shares have slumped 7.3 percent.

* Thai stocks, up 23.9 percent in the past 12 months, have reversed course and declined 6.2 percent in June.

But the fiercest sell-off has occurred in global fixed-income markets. According to Bloomberg, global bond fund outflows accelerated to $14.5 billion last week, surpassing the previous record of $12.5 billion in selling set just two weeks ago.

The Market Vectors Emerging Markets Local Currency Bond ETF (EMLC) plunged more than 10 percent since May 1 before bouncing back a bit. The fund is down 8.7 percent this year. Foreign investors have sold $3.7 billion worth of Indian bonds over the past three weeks alone.

To me, this looks like a classic unwinding of carry-trades, as hedge funds and other big institutional investors take their “easy money” profits off the table, thanks to rising yields in the U.S. and Japan. That would also explain the recent counter-trend rally in the oversold Japanese yen as investors buy back to close their short yen positions.

Seeing Through the Storm Front

The question is, will this prove to be nothing more than a brief squall or is it the front of a major financial storm?

It’s too soon to say if the Fed yesterday added any lasting clarity to the QE-tapering debate. That’s why I’m keeping a watchful eye on market-based measures of inflation expectations. And should 10-Year Treasury yields peak and begin to decline in the weeks ahead, that would be an important clue that the risk-on vibe is returning.

If selling dies down in emerging-market stocks and bonds, there may be great buying opportunities. For instance, in Philippine stocks (you can use the iShares MSCI Philippines ETF — EPHE) and Thai shares (iShares MSCI Thailand ETF — THD). The Market Vectors Emerging Markets Bond ETF, mentioned above, offers an annual dividend yield of 5.4 percent, paid monthly.

Global markets have been teetering between risk-on and risk-off ever since the financial crisis began nearly five years ago. Shifts, fueled mainly by central-bank money printing (or the lack of it), alternate between brief, but often sharp, corrections, followed by powerful rebound rallies. Navigating those twists and turns can be tricky, but following the key market trends and watching out for the red flags can bring rich rewards.

Mike BurnickWritten By Mike Burnick From Money And Markets

Money and Markets is a free daily investment newsletter published by Weiss Research, Inc. This publication does not provide individual, customized investment or trading advice. All information is based upon data whose accuracy is deemed reliable, but not guaranteed. Performance returns cited are derived from our best estimates, but hypothetical as we do not track actual prices of customer purchases and sales. We cannot guarantee the accuracy of third party advertisements or sponsors, and these ads do not necessarily express the viewpoints of Money and Markets or its editors.

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