After initial strength this year, investors are reeling from Wednesday’s market backlash. The Federal Reserve’s Federal Open Market Committee (FOMC) meeting minutes are to blame, but let’s take a look at specifically what spooked the markets.
The Fed has been taking a very aggressive stance in its monetary easing policy. As we look at the FOMC, we can essentially break it out into two factions: the dovish faction and the hawkish faction.
The hawkish faction are FOMC members that are more concerned with the potential risks of having too accommodating of a monetary policy. They’re worried about inflation. They’re worried about potential damage that could be done to the economy.
Dovish members of the FOMC are those who are more willing to lower interest rates, to have an accommodative monetary policy and to try and do whatever the Fed can do from a monetary standpoint to stimulate the economy.
What traders caught from the latest FOMC meeting minutes was an increase in hawkishness. What’s interesting is that during the past couple of years, we’ve seen an interesting relationship in the stock market. What would happen is when we’d get negative economic announcements, like a bad GDP report or a bad employment announcement, we’d see the stock market start to rise. It left everybody scratching their heads because typically if you have negative economic announcements, you tend to see the stock market moving lower, as well.
But we weren’t seeing that. We were seeing the stock market move higher. This relationship was being driven by the expectations that investors had for the actions that the Fed would take to try and stimulate the economy. So the worse the economic picture got, the more convinced traders on Wall Street became that the Fed was actually going to step in and try to do something to spur on the U.S. economy by lowering interest rates and by injecting money into the market.
Currently, the Fed is injecting $85 billion into the economy every month. They’re buying $40 billion worth of agency mortgage-backed securities and they’re buying $45 billion worth of U.S. Treasuries.
Well, everyone has been wondering how long that’s going to last. They’ve been wondering if the Fed would slowly start to ease out of that number and, instead of just pulling the plug on that spending, maybe if the Fed started to see some improvement in the economy, they would drop down to $75 billion a month, and then incrementally step down, gradually reducing the amount of money that they were putting into the U.S. economy.
However, when investors started to digest what they were reading from the latest FOMC meeting minutes, the selling commenced.
What we’re starting to see is relationship between the stock market and economic data reversing. Now, everybody’s concerned that the Fed is going to start taking some of that monetary stimulus away, taking the punch bowl away from the party, and people are going to be left on their now. So, now, when we start to see positive economic reports, we have the potential of pullbacks on Wall Street as investors start to take some profits off of the table while wondering if the Fed is going to start scaling back the stimulus as they start to see encouraging economic signs.
Our hope is the Fed will leave the stimulus in place long enough to get the economy to a point where it can maintain itself, but if the Fed doesn’t, everybody’s concerned that the economy will come crashing back down. It’s a real point of concern for a lot of investors, and it’s one of the reasons we’ve remained cautiously optimistic but ever-ready get more exposure on the bear side. In fact, our SlingShot Trader portfolio is holding a mix of puts and calls right now, and we’ve got a bearish bias on a recent Trade of the Day in AOL (NYSE:AOL).
Investor Place advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.