The end of Quantitative Easing (QE) is coming one day; the Fed put everyone on notice with four Fed officials discussing the 'taper' of open market security purchases.(i) Many people believe the money printing from the Fed went directly into the stock market and that these dollars are what is propelling the equity markets to new all-time highs. While they are somewhat right in form, they are wrong in substance. The Fed is not buying equities, but it is shrinking the supply of Treasuries and replacing them with cash. Repressing the interest rate curve is what the Fed is intentionally doing, and in so forcing the marginal investor higher than he or she would normally have to venture along the risk curve to earn satisfactory returns.
(Note these are not projections, simply the yield on fixed income and forward earnings yield on equities.)
These actions made the returns of less risky assets on the left side unattractive and thus reflated asset prices on the right side.
But despite the run-up in equity prices, mutual fund investors switched out of the anemic returns of cash and into bonds while shunning equities.
Source: Morgan Stanley Research
For households that became overleveraged during the past real estate cycle, the low rates and rising asset prices helped improve the collective household balance sheet. Below is the household debt to GDP ratio, which this past quarter fell back to the same level as in 2003.
Because households focused on the repairing of balance sheets, demand for credit was low. The price of credit, i.e., interest rates, being so low, did not matter. Since lenders are weary of risky borrowers, credit standards also tightened. This led to money velocity being quite low, as credit has not really expanded even with the Fed holding rates down and repressing the investment opportunity curve. This is also a reason why inflation has not exploded despite the growth of the Fed's balance sheet.
With rhetoric discussing less open market purchases, the Fed is keenly watching these statistics. The other statistic Fed officials are watching is the unemployment level, as they stated back in December that should unemployment fall below 6.5% and inflation rises above 2.5%, a tightening cycle may begin, which would have repercussions for fixed income securities.
One factor driving the unemployment rate other than actual jobs is the labor force participation rate.(ii) Because baby boomers are a large part of the population, the demographic trend naturally skews older over time. Since retirees leave the labor force, they are not counted in the participation rate. A mathematician developed a very interesting model for forecasting unemployment based upon the labor force participation rate and it has efficacy across countries and over time.(iii) In fact, the model explains 82% of variation in the unemployment rate.
The current projections are for an unemployment rate of 6.0% at the end of 2013, from today's level of 7.5%. This is far lower than consensus forecasts and would accelerate the tightening of Fed policy should it turn out to be correct. While wildly optimistic, it is food for thought as the U.S. economy surprises the doubters.
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