EC When Is The Next Bear Market? 3 Things Will Tell

They will likely be wrong again.

Fed Taper

Recently, the Federal Reserve stated they are “thinking about thinking about tapering” its bond purchases. However, the issue of “tapering” is not as much about the Fed’s actual reduction of bond purchases as it is about psychology.

“The key to navigating Quantitative Easing! and Fed policy in general is to recognize that their effect on the stock market relies almost entirely on speculative investor psychology. See, as long as investors get inclined to speculate, they treat zero-interest money as an inferior asset, and they will chase any asset with a yield above zero (or a past record of positive returns). Valuation doesn’t matter because investor psychologically rules out the possibility of price declines in the first place.” – John Hussman

In other words, “QE” is a mental formation. Thus, the only thing that alters the effectiveness of the Fed’s monetary policy is investor psychology itself.

Such was a point made in the “Stability/Instability Paradox.”

“With the entirety of the financial ecosystem now more heavily levered than ever, due to the Fed’s profligate measures of suppressing interest rates and flooding the system with excessive levels of liquidity, the ‘instability of stability’ is now the most significant risk.”

There is a correlation between expanding the Fed’s balance sheet and the S&P 500 index. Whether the correlation is due to liquidity moving into assets through leverage or just the “psychology” of the “Fed Put,” the result is the same.

Therefore, it is no surprise that market volatility increases when the Fed starts “tapering” their bond purchases. The grey shaded bars show when the balance sheet is either flat or contracting.

Notably, the time from the initial tapering of assets and a market correction is almost immediate.

However, taper leads to rate hikes.

Fed Rate Hikes

The risk of a market correction rises further when the Fed is tapering its balance sheet and increasing the overnight lending rate.

What we now know, after more than a decade of experience, is when the Fed slows or drains its monetary liquidity, the clock starts ticking to the next corrective cycle.

As discussed previously, the Fed should use the $120 billion in monthly QE to hike rates and prepare for the next recession. But, instead, they continue to kick the “policy can” further down the road. The longer they wait, the harder it will be to normalize policy without risking significant market volatility and reversing the economic recovery.

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Mike Nolan 2 months ago Member's comment

Good, informative read, thanks.