05/07/14   What Happens When The Fed Stops Buying And Starts Selling?

Editor’s Corner

Ron Rowland

Fed Chair Janet Yellen testified to the Joint Economic Committee on Capitol Hill today.  She revealed no surprises and generally stuck to the same script that has been in use for months.  While basically optimistic on the economy, she reiterated concerns about the labor market, lack of inflation, and disappointing housing activity.  She believes the lackluster first quarter GDP figures were mostly weather related and sees signs that spending and production are rebounding.

The Fed’s monthly reductions of asset purchases this year have been based on its assessment the economy was strong enough to support labor market improvements.  Yellen reminded everyone that this tapering operation was still adding to the Fed’s holdings, and they in turn were helping apply downward pressure on long-term interest and mortgage rates.

Last year, the market reacted negatively to the idea of the Fed tapering its monthly purchases of Treasury and mortgage-backed securities.  Tapering is one thing, but what happens when the Fed starts to reduce its balance sheet?  This is seldom discussed, but today Ms. Yellen stated the Fed does in fact expect to shrink its balance sheet over time.

Outright sales of mortgage-backed securities are not planned, with the possible exception of eliminating some residual holdings.  Instead, balance sheet reduction will occur by not reinvesting the proceeds the Fed receives when current holdings mature.  Although the Fed intends to avoid sales of mortgage-back securities, no such assurances regarding Treasury securities were offered today.

Earlier this year, with the unemployment rate hovering around 6.7%, the Fed eliminated its 6.5% line-in-the-sand regarding when it would begin considering the reduction of monetary stimulus.  The reason for this change was the belief the unemployment rate didn’t fully reflect problems within the labor market.  Last Friday, the Bureau of Labor Statistics released its April employment reports, and the official unemployment rate plunged a staggering 0.4% to 6.3%.

Today, Ms. Yellen again emphasized that labor markets are still far from satisfactory.  People out of work for more than six months and those only able to find part time work remain at historically high levels.  The declining participation rate is also a concern, as another 988,000 people left the labor force in April.  For these reasons, she believes the Fed was correct in removing the 6.5% threshold.

Markets reacted favorably to all this, giving the relatively new Fed Chief an implicit seal of approval.  The Dow Jones Industrial Average climbed more than 117 points, and the 10-year Treasury yield dropped back below 2.6%.

Investor Heat Map: 5/7/14

Sectors

Energy and Utilities have been swapping places for the lead the past four weeks, and Energy came out on top today.  Utilities had a setback last Friday with earnings misses and downgrades among prominent constituents.  The sector is bouncing strongly today and is well on its way to reclaiming the top spot from Energy.  Real Estate and Consumer Staples hold down the third and fourth spots for the fourth week in a row.  Telecom jumped four places after falling the same amount the prior week.  Unfortunately, the group looks like it may not be able to maintain its upward momentum, making it vulnerable to downside action.  Materials and Industrials have been hanging out in the middle of the rankings for more than a month now.  Technology is another sector on the verge of slipping into a negative trend.  The selling in biotechnology stocks seems to have subsided for now, but the Health Care sector is still struggling to regain its footing.  Earnings out of the Financials haven’t been offering much hope for the group.  Consumer Discretionary continues to encounter setbacks and remains mired at the bottom of the heap.

Styles

Although three pairs of style categories swapped positions, very little has changed.  Large Cap Value remains at the top but seems to be settling into a mostly sideways pattern.  Mid Cap Value exchanged places with Mega Cap to recapture second place after a one-week absence.  Large Cap Blend, Mid Cap Blend, and Large Cap Growth continue to hold down the middle.  Mid Cap Growth and Small Cap Value comprise our second pair of categories swapping places.  Mid Cap Growth came out ahead this week and even managed to generate a slightly positive momentum reading.  Small Cap Blend remains in a negative trend near the bottom of the rankings.  Micro Cap slipped below Small Cap Growth to take over last place.  Seven weeks ago, Micro Cap was at the top, but now the tables have turned.

Global

We have been commenting for many weeks about the late March surge for Latin America.  Since then, it has been digesting those gains and unable to break out of its long-term downtrend, until now.  Brazil and Mexico are currently providing the strength for Latin America funds.  The U.K. continues to get a currency translation boost, allowing it to climb two spots to second place.  Canada strengthened its grip on third place with gains in both equity prices and the Canadian dollar.  Pacific ex-Japan slipped two places to fourth as stronger groups moved ahead.  The next five categories are keeping the same relative rankings and nearly identical momentum readings as last week.  Europe heads up this group of five, followed by Emerging Markets, EAFE, World Equity, and the U.S.  Two global categories are in the red, and this week they swapped positions with China replacing Japan at the bottom.

Note:

The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.

 


“This ‘don’t worry, be happy’ monetary message isn’t working.”

U.S. Representative Kevin Brady on May 7, 2014


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