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How Does the Market Perform in a Dual Target Monetary Policy Environment?

FOMC Minutes for March revealed that the Fed expects to start shrinking its balance sheet.

Via TeroVesalainen

Last Wednesday, FOMC Minutes for March revealed that the Fed expected to start shrinking its $4.4 trillion balance sheet late this year. The stock market has since altered its bullish stance to a bearish one, with major indexes up in the morning, then drifting down in the afternoon for four days in a row. Investors are feeling a little uneasy about the Fed unwinding its giant holdings in Treasuries and mortgage securities.

Will the Fed’s phasing out of reinvestments constitute a catalyst for the market to be topsy-turvy? Since the 2008 Financial Crisis, the Federal Reserve had been lowering interest rates and purchasing securities to revitalize the economy. In December of 2015, the Fed reversed its easy monetary policy by staging an interest rate-hiking cycle. Much research has evidenced that raising interest rates will not necessarily end the bull market.

When the Federal Reserve trims its balance sheet, it essentially reduces its monetary supply (M1, M2, M3, etc.). If the economy booms, consumer confidence will rise, and consumers will speed up their spending, thus increasing the velocity of money. Imagine Economy A has $100 money supply, but there is only one transaction at $100. Now, Economy B has $50 in money supply, but has two transactions each at $50. Two economies will have the same amount in transactions, i.e. same GDP. The case is extremely simplified, but it can be utilized to dispute the market’s jitters due to the news of the Fed’s diminishing balance sheet.

Unlike the Greenspan Era of the 1990s, when the Federal Reserve mainly relied on inflation targeting monetary policy to achieve great prosperity with low inflation, the current Fed will undergo two unprecedented tasks at the same time: Raising rates, while seeing its balance sheet dwindle. As long as the Fed continuously adopts an explicit nominal anchor policy in transparent ways, communicating with the market with enough time so that it can discount its intention and action, the fear and panic from investors will have a good chance of dissipating, even without fiscal stimulus.

Nominal anchors here brace for a longterm 2% inflation target and mid-term annual unwinding amount of balance sheet. In these years, the Federal Reserve can trim its current $4.4 trillion balance sheet to $ 1-1.5 trillion, 30% above a pre-crisis $870 billion. With forward looking methods, the real shrinkage of balance sheets will be much lower. If the average annual GDP growth rate is 2% in the next 10 years, the corresponding Fed balance sheet could be $1.5 to $2 trillion. Therefore, the Federal Reserve would only need to shrink less than $2.5 trillion in 10 or longer years, which equals 10% of a total equity market cap of $24.5 trillion. This is an amount that the market can easily digest.

Markets frequently follow a very few leading stocks. FAT stocks ((FB), (AAPL), and (TSLA)) seem to shepherd the tone of markets now. If more buys than sells happen on these stocks, the overall market will have a low probability of falling apart. Earnings season is coming soon, and the market may wait for a reality check on President Trump’s first 100 Day performance before it moves away from its range-bound area: S&P 500, 2300—2400.

Weeks ago, I recommended selling Western Digital (WDC) and moving on. Since then WDC climbed almost 20%, slapping my face without any thought. In investing, sometimes you need to be nimble: when WDC moves back up to a 50 Day move average again, sending a buy signal, you should join the party right away.

I also commented on Applied Optoelectronic Inc. (AAOI) at the same time. It once rose 20% from $48 to $60 in one week, and now pulls back to $44, struggling around a 50 Day moving average, well below the prices I talked about. How do you deal with this tough situation when you have 20% profit while it disappears in a blink? First, you should never allow a 20% profit to become a loss. Second, when technical indicators show some weakness in prices around $55, you should take some profit. To my view, the AAOI story is still intact – its fundamentals are still in good shape. The technical chart shows only the second consolidation in price, and the first time its prices retreated to the 50 Day moving average line. However, overall market nervousness may yield a larger effect on AAOI price.

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This is just a personal opinion, and personal opinion is often wrong. Currently, the author has no position on any of the above mentioned stocks, and may or may not build any position on any stocks above in the future.