Traders have for months been focused on the threat of a taper, but Ben Bernanke and the Federal Reserve continue to be concerned about making sure the market knows that even if QE is reduced, low interest rates or ZIRP (zero-interest-rate policy) will continue. Even if growth gets better and unemployment falls, the Fed plans to keep rates extremely low.
Investors have to realize there’s a difference between quantitative easing/bond buying and just keeping interest rates low, and it’s an important one.
The difference between these two ideas relates to the financial concepts of “stock and flow.”
- Stock is a measure of an asset that exists now and can be counted. Don’t confuse the word in this example with a “share of stock” — they are two different things. For example, a bank has assets that you can identify and measure — such as loans outstanding, deposits and reserves — that we could call stock.
- Flow is a measure of what is happening to an asset over time. For example, new loans made, purchases and interest payments are all considered flow.
Simply put, the Fed has a stock and flow problem. Bernanke wants to keep investors focused on the stock of capital regardless of what happens to the flow of capital through QE. To keep interest rates low, the Fed has increased the stock of reserves held by banks.
For example, in the chart below, you can see that banks are holding excess reserves of almost $2.4 trillion. That is where much of quantitative easing has landed. The Fed hasn’t been “printing” money — it all got stuck in reserves as stock.
We can go back in time to prior recessions to see if this growth in reserve stock has ever happened before, but we know it hasn’t.
The problem is that flow of capital is going into the economy from the Fed to the banks, but then it stops and gets stuck. Large excess reserves like this will likely keep rates low as Bernanke promises, but that isn’t what concerns investors. They are worried about the flow of capital … and since the Fed is one of the most prominent sources of flow right now, they remain unconvinced that low interest rates will lead to high growth. A few papers written by the Federal Reserve’s own economists make this point as well.
Growth likely will continue, and rates will stay low while flow-through quantitative easing remains intact. How to get that flow to actually come from the banks rather than the Fed is a problem that no one has solved yet.
How Did Investors Respond?
Despite our skepticism, investors haven’t laughed off Bernanke’s latest comments, made Tuesday. The dollar reacted and risk-on assets did fairly well initially. For example, in the currency market, the Japanese Yen-based carry trade got a little boost from Bernanke’s comments. However, that has started to fade, as you can see in the next chart of the EUR/JPY exchange rate.
Why should investors care?
We use the carry trade — and specifically that of the EUR/JPY — as a proxy for risk appetite. If investors are doing well in the carry trade, then we expect stocks to be correlated. However, the carry trade has been consolidating for a while in an “ascending wedge” pattern and is losing momentum. Earlier this month, we had a small breakout below support that was accompanied by very strong volatility in the stock market as well.
Prices probably are heading back to support again, and that could create some short-term headwinds for stocks.
We actually can’t criticize the Fed too much for attempting to communicate to the market. They have admitted to being surprised to the strong negative reaction at the threat of a taper and are trying to make a case to investors that their future plans are sound and will be effective.
We think more communication is a good thing. In this case, it’s doubly important because we are coming up on the next FOMC meeting on Dec. 18, which will include the Fed’s growth projections and potential hints about the future of QE.
As we get closer to that date, we would not be surprised to see the S&P 500 ease off a little and hit support near 1750. That could present some very interesting bullish opportunities that could be held for a longer-than-average time frame.
InvestorPlace advisers John Jagerson is a co-founder of LearningMarkets.com, as well as a co-editor of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Follow John Jagerson on Google+!