Fed Misstep Triggering Equity Market Exodus

Markets sold off sharply Wednesday, trending lower for most of the session to finish with some of their sharpest losses of the year. The Dow dropped 1.43%, relinquishing the psychological 15,000 level, while the S&P and Nasdaq finished down 1.38% and 1.27%, respectively. The headlines continue to focus on the expectations for less accommodative monetary policy from the Fed going forward based on recent comments from Fed governors about the potential for QE “tapering” by September.

The sell-off in US markets pales in comparison to what we’ve seen in Japan, where the once high-flying Nikkei has now corrected almost 20% off its highs. Prime Minister Abe’s much-balyhooed three-pronged “Abenomics” plan for jump-starting the Japanese economy has so far been underwhelming, and investors are starting to worry about the unintended consequences of his unprecedented policies. It will be interesting to see whether Japan can find its footing tomorrow, or whether the downward spiral continues.

Over the last few years, the Fed has supported asset prices and created inflation expectations through rate cuts and asset buying programs, aka QE. Inflation itself has remained lukewarm, and the employment picture has not improved as hoped, but with corners of the credit market showing signs of overheating, there have been suggestions in recent Fed minutes that several FOMC voting members are keen to “taper” QE, or decrease the pace of purchase of the program. These expectations for more hawkish monetary policy have driven bond yields higher, and triggered a so-far controlled exodus from equity markets, but that exodus could certainly intensify.

I think the Fed has made a mistake in hinting at QE tapering before it was actually ready to pull the trigger. Market expectations have been reshaped, and I don’t think that’s a positive. Prior to talk of QE tapering, as far as economic data goes, good numbers were good news, and bad numbers were better news because it was perceived that a slow recovery would extend dovish monetary policy indefinitely. Now, though, with expectations that QE could start to be wound down, that dynamic has been flipped on its head. Bad economic numbers are being perceived as bad because they are evidence that the recovery is not taking hold, but good economic numbers are being perceived as just as bad or worse because they could lead to a quicker exit from QE.

The takeaway is that market EXPECTATIONS for the future of interest rates and QE are just as, if not more, important than the ACTUAL rates and QE themselves. Chairman Bernanke has always understood this nuance better than his colleagues, and he is likely frustrated at their lack of discretion in recent public comments. The Fed has painted itself into a corner, and the market is reflecting that. After Monday’s ISM reading showed contraction in the manufacturing sector–the reading of 49 being the worst in four years–the reaction to Friday’s jobs report, whatever it may be, will be very telling, indeed.

Disclosure: Scott Redler is long SPY put spread and AAPL call spread.

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