Over the past few years, the Federal Reserve has implemented an unprecedented experiment in the form of monetary stimulus commonly called “quantitative easing;” I’ve called it a “confidence game.” All it means is that the Fed buys long-term Treasury bonds and mortgage-backed securities to keep the interest rates on those securities very, very low.
The major problem with this in practice is that many investors have viewed this as a permanent, underlying bid. They have believed the Fed will put a floor under the bond market allowing investors to use it as a backstop and even justification for venturing into riskier securities, like stocks.
Stanley Druckenmiller recently phrased it like this: “…The most important price in the most important economy in the world is being rigged, and everything else is priced off it…” including our stock market and other various asset markets around the world. So what happens if that price becomes unrigged?
This week, Ben Bernanke suggested just that. He revealed to the world that the Fed is considering when to reduce its bond purchases. Essentially the Fed is considering unrigging the, “most important price in the most important economy in the world,” the price for which, “everything else is priced off.”
The reason that this is so momentous is that for the past 5 years investors have made decisions across multiple markets that were predicated on this price being supported by the Fed. If this support is removed those investors are forced to reverse or unwind their investment decisions.
So to a very large (but ultimately unmeasurable) extent financial markets are more dependent upon the Fed’s QE activities than normal investment criteria like interest rates (in a free market), earnings, inflation, etc. This is why Todd Harrison recently called this, “the most F.U.B.A.R. environment I’ve ever seen.” It’s not about anything but the Fed.
Because their investment value is negligible (see: Right Now Is One Of The Worst Times To Buy Stocks In The Past 40 Years), buying stocks today, or any time over the past few months really, is really a bet on two things: 1) that the Fed will continue to support asset prices by manipulating long-term interest rates, and 2) they are capable of doing so without causing major problems (dollar collapse, blowing up their balance sheet, runaway inflation, or merely losing investor confidence as policies lose efficacy).
Stocks sold off this week as #1 took a major blow. Ultimately, however, if the Fed decides to keep up its QE programs (and I think they will) #2 could cause an even bigger nightmare for investors. It’s a grand confidence game that, to a large extent, has been a major boon to asset prices across multiple markets… until now.