Brief Selloff a Reminder of ‘In Fed We Trust’ 

Kristina Hooper 

The Upshot 

2/25/2013 

The January FOMC minutes may have spooked investors by revealing a rise in hawkish sentiment, but the Fed isn’t likely to take away the punch bowl any time soon, says Kristina Hooper.
Kristina Hooper, CFP®, CIMA®, is US head of investment and client strategies for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.

What a difference a few minutes make.

Stocks started the year with a six-week winning streak as economic conditions continued to improve and central bankers maintained an accommodative monetary policy. But investors were briefly shaken by last week’s release of the minutes from the January Federal Open Market Committee meeting. In fact, the stock market sold off significantly on Wednesday; while it had recovered by the end of the week, the rebound wasn’t enough to prevent the first weekly drop for the S&P 500 in 2013.

The minutes frightened investors because they indicated that FOMC members had an in-depth discussion about the continuation of the asset-purchase program, as there seemed to be more concern than ever before about further bond buying. Some members expressed concern about the possibility of inflation over the medium- and longer-term. Others feared that the Fed’s policies may foster risk-taking behavior that could ultimately undermine financial stability. In addition, there was concern that the Fed could be exposed to significant capital losses when its large portfolio of long-duration assets is unwound. And some committee members worried about the potential risks of further asset purchases on the functioning of the financial markets, although others noted that there had been little evidence to date of such effects.

Balooning Balance Chart

Dissenting Opinions

There seems to be resolve among the FOMC members to monitor the asset-purchase program more closely, which, in turn, means they are closer to acting on their concerns. One FOMC member argued that the level of asset purchases needs to be adjusted after each committee meeting, depending upon the data. Bottom line: the asset-purchase program is likely to receive greater scrutiny going forward and runs the risk of either being altered or stopped in the near term.

This sentiment rippled through the stock market last week. An end to or modification of the purchase program in the short term means we would lose one of the few tools—and arguably the most effective tool—the Fed has at its disposal. That’s because the Fed has not just been embarking on quantitative easing, but also “qualitative easing.” Qualitative easing is a term coined by Willem Buiter, a professor at the London School of Economics, to describe an asset-purchase program that involves a diversification into riskier and less liquid assets. It’s through the Fed’s qualitative and quantitative easing that we have seen long rates fall and more liquidity in the mortgage market, both of which have supported housing and the consumer. In fact, some market observers attribute the Fed’s success with its quantitative-easing program relative to the Bank of Japan to its use of qualitative easing at the same time.

We know that the consumer represents more than two-thirds of GDP and that research shows housing generally has a greater impact on consumers’ perceived wealth than the stock market. Therefore, it stands to reason that investors would be shaken, at least temporarily, by the threat of a pullback in asset purchases while the economy still seems fragile.

The Bigger Picture

Still, something bigger may be at stake here, resulting in such a significant market reaction: fear that the Fed may limit its role in supporting and growing the economy. Consider the headline in this weekend’s Wall Street Journal entitled “Japan Seeks Ticket to Growth from New Central-Bank Chief.” Or that last year it took European Central Bank President Mario Draghi’s pledge that the ECB would embark on an unlimited bond-buying program in order to support euro-zone stocks and dispel concerns about a Eurozone breakup. All around the world, fiscally-challenged countries are looking to central banks to be the economic stimulators of last resort. And most central banks have delivered on that expectation, purchasing assets and injecting liquidity into their economies. However, the need clearly remains and any sense that a central bank such as the Fed is abdicating this role is a cause for a crisis in confidence.

But investors should not despair. Don't forget that Fed Chairman Ben Bernanke and Vice Chair Janet Yellen are still very much in favor of further asset purchases. So it seems unlikely that the Fed will stop its asset-purchase program entirely any time soon, especially with unemployment at 7.9% and economic growth still very sluggish. After all, it seems investors won’t allow the Fed to shirk its responsibility as a central bank to be the stimulator of last resort.

Eventually, central bankers will have to pass the baton to businesses and consumers to keep the economy growing. But for now, the Fed is the fuel that makes the markets go.

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The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

 
Past performance of the markets is no guarantee of future results. This is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities.


A Word About Risk
: Equities have tended to be volatile, involve risk to principal and, unlike bonds, do not offer a fixed rate of return. Foreign markets may be more volatile, less liquid, less transparent and subject to less oversight, and values may fluctuate with currency exchange rates; these risks may be greater in emerging markets.
 
The Standard & Poor’s 500 Composite Index (S&P 500) is an unmanaged index that is generally representative of the U.S. stock market.

Gross domestic product (GDP) is the value of all final goods and services produced in a specific country. It is the broadest measure of economic activity and the principal indicator of economic performance.

Allianz Global Investors Distributors LLC, 1633 Broadway, New York NY, 10019-7585, us.allianzgi.com, 1-800-926-4456.

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