Fed Lost Their Mojo Apr23

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Fed Lost Their Mojo

Has the Fed Lost Their Mojo? by Brandon Wendell

A popular question when I was being interviewed by the Indian media was, “Do you think the Quantitative Easing Part 2 will work?” My immediate response is usually, “If the QE program by the Fed is so effective for getting the US economy on track, why did we have to have a second round?”

The thought behind the program is for the Fed to pump additional dollars into the markets and devalue the US dollar as a result. Theoretically, this will lower the costs of American exports and stimulate the economy. Unfortunately, there is an adverse effect of too much currency and we are seeing that effect in the rising costs of goods and services commonly known as inflation.

Last week, I wrote about how to identify the Fed’s effect on the bond market and therefore, the equity market. This week, let’s examine the result of the start of QE2 from the market perspective. When inflation or deflation becomes a real threat to the economy, people will turn to the safe haven of gold as a real currency. We saw a huge bull run on gold culminating with it reaching an all-time high of $1424/oz. on November 9th. However, as the Fed started their active purchasing, you can see that traders were not as worried as gold retreated sharply from those highs.

 

Figure 1

 

Let’s turn our attention to the bond market. Here we can see truth to the saying, buy the rumor…sell the fact. In the time leading up to the Fed’s official announcement of QE2 becoming a reality on November 3rd, the bonds were in a strong bull run. Once the Fed stated that QE2 was a reality and was slated to start, the bonds went into a selloff. The problem with the prices of bonds falling is that interest rates move in the opposite direction. Rising rates will cause a slowdown in the same economy that the Fed is trying to rescue. This selloff shows the lack of confidence in the Fed that the traders have. Those bond traders include many institutions and other economies.

 

Figure 2

 

Finally, we can see that the equity markets are following the bond market as they normally do. The Fed’s initial purchase of treasuries as part of QE2 began on November 12th. In the preceding bond charts, you can see how this halted the decline of treasury prices for the time being. The US equity markets are following the lead of the bond market as seen from the charts of the 10-year treasury price vs. the S&P 500.

 

Figure 3

 

But has the damage been done? We asked has Fed Lost Their Mojo at the begining of this article.┬áIt is obvious that the markets do not believe that the Fed’s QE2 will have a dramatic effect of rescuing the US economy and other world leaders are even going as far to say that it will hurt the global recovery. Only time will tell but in the meantime, watch the treasury markets for signs of the direction of the stock market. Until next week, trade safe and trade well.

Have a great day.

– Brandon Wendel