The Fed is now in an impossible position with regard to tapering-off their massive stimulus program – QE3 (quantitative easing round 3). If they continue to buy $85 billion each month in long-term bonds, they risk sparking inflation. If they try to taper-off their buying, they risk stifling the economy and potentially crashing the stock market.
Recent action in the Japanese stock market may be a bad omen for U.S. stocks. The NIKKEI 225 Index has plunged 13.5% in the past 6 trading sessions. Japan’s government, just as in the U.S., is driving stock market performance through massive stimulus in an effort to improve economic growth. The result has been unprecedented stock market expansion, with the NIKKEI rising 82% from the low in November of 2012 and 50% year-to-date before the recent drop. The Dow has had a similar run, albeit not as dramatic, rising 23% from its November low, an increasing 16.7% year-to-date. The only real difference between the two markets is that the Dow has yet to correct.
Despite the Fed’s best efforts to allay fears about the impending end to QE3, investors will very likely react aggressively and dramatically to any slowing of bond purchases by the Fed. In fact, the bond market is already showing signs that investors are anticipating this, as the 10-year treasury yield has already risen from a low of 1.66% on May 2, 2013 to the current 2.12%. While this may not seem like a significant move, it represents a 28% increase in the 10-year yield. The amount of selling pressure necessary to cause a move of this magnitude is mind-bending, especially since the Fed is making its purchases at the same time – the selling must offset Fed buying and still be enough to push prices down/yields up.
With May coming to an end, we can look back and see that “sell in May and go away” never materialized. To some this may be a sign that we will not experience a meaningful correction. To me it shows the powerful impact of the Fed’s manipulation of the financial markets, which is all the more reason to fear the negative impact of any change in Fed bond buying policy. We know the end to QE3 is not a matter of if but when, and that when could come as soon as next month.