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Will The Fed Pull The Rug Out From The Markets?

What Has Actually Occurred?

In 2008 the US Federal Reserve embarked on an aggressive spending spree by purchasing $600 billion in mortgage-backed securities (debt) as well as other asset classes. By recent figures in 2013 their balance sheet has grown to a staggering $3.6 trillion.

To fund such enormous purchases the Federal Reserve is effectively printing more money, and in turn, this has resulted in interest rates in the United States being driven to record lows.

The ulterior motive behind this action is to encourage investors to take money out of the banks (savings accounts) and put it to work in higher returning investments (like the stock market). This manoeuvre on the Fed’s part has helped push the Dow to all time highs in mid September 2013.

US 2008 - 2013_2

Click to Enlarge – US 2008 – 2013

 

When a market reaches new highs, generally that economy should be doing well, which will encourage job creation and further growth of the economy.

Has This Happened In The Past?

The short Answer is ‘yes’. Japan started to collect debt on their balance sheet technically from around the 1990’s and now the debt to GDP is expected to be around 247%, which is the largest debt to GDP ratio than any other country in the world. And in 2001 Japan implemented a similar version of quantitative easing that the Federal Reserve used, however as you can see in the chart below it failed to drive the markets and growth higher.

Click to Enlarge - Nikkei 1990 - 2013

Click to Enlarge – Nikkei 1990 – 2013

 

But what’s interesting is the effect that monetary stimulation had on these two economies (US and Japan). They did the exact opposite thing – the US market reached record highs as a result of monetary stimulation, whereas the Japanese market reached record lows.

But having said that, it doesn’t necessarily mean that the state of the US economy is any better off than Japan’s as a result of their monetary policy adjustments. Job growth and employment figures in the US do not reflect the same growth as that of its markets.

There is no strong evidence that suggests that monetary stimulus is a short term solution to increasing growth. We can expand by taking a look at Japan and the UK as examples – both are printing money at approximately 20% of their GDP, but both economies have not increased growth to sustainable levels.

Click to Enlarge - Ftse 2009 - 2013

Click to Enlarge – Ftse 2009 – 2013

 

Click to Enlarge - Nikkei 2000 - 2013

Click to Enlarge – Nikkei 2000 – 2013

What Does This Mean As A Trader?

If you are a long term trader who looks at the markets over a long-term period you will notice there is usually a significant recovery after a market correction, hence there may be opportunities after these events.

If The Fed ‘Pulls the Rug’ Then What Can We Expect?

The next big challenge the Federal Reserve faces will be when and by how much to reduce, and/or remove the liquidity flow out of the markets and allow the markets to re-adjust.

There are a few things to consider in ascertaining the answer to this:

  • Is the economy growing at a good pace?
  • Is the job creation enough to sustain growth?
  • Will printing more money without economic growth cause higher inflation?

For the equity markets to continue going up the general rule is that companies need to grow year on year (YoY).  But if a company grows by 2% this year and then does not grow the following year, then that is not a good thing for the economy.

For new jobs to be created companies need to grow and feel confident that the growth is sustainable for the next 10+ years. If they are not confident of this, they will employ less staff and see how things develop before making the decision to hire more staff and thus create more jobs.

If neither of these two scenarios improves then how could the Federal Reserve remove the money flow that is technically supporting the financial system?

If the Federal Reserve reduces or stops the amount of money it prints too early, then the financial system could run the risk of ‘breaking’ once again. As without money flow there will be no investments or no growth which in turn creates more jobs. It’s a catch 22 situation.

A significant risk that the Federal Reserve faces is if the markets start to adjust by themselves, and if the bond market starts to rally and interest rates rise, then the Fed may not be able to maintain control.

How Do You Position Yourself As A Trader?

Traders need to think ahead of the curve and realise that higher interest rates are a possibility. It’s also important to realise that companies that have been profitable in a low interest rate environment may not have the same effect when costs begin to rise.

Some useful points to remember:

1. Start Small

Many traders think they have worked out the markets and enter trades too aggressively. But far too often they are met with a rude awakening.  At Trade View Investments we enter trades lightly (small positions) and then if we are confident with how our trades are looking we may increases sizes. This is a discipline that many traders lack, as they hold the belief that they are entering into the one trade that will make them rich.

2. Spread Your Risk

In times like this it is extremely important to spread your risk across multiple markets and across multiple instruments, as well as trading both sides of the market (Long and Short). The main reason for this is to counter sharp moves that may occur in the markets after major announcements. It will also allow for you to be involved in the markets for a longer period of time, rather than continually getting stopped out and being one directional.

3. Don’t Forget The Other Markets (Watch Europe and China)

Traders often get caught up in the headline news and forget that there are other countries and implications that they should be keeping their eyes on as well. A slowdown of growth in one country could lead to a slowdown in another. And several slowdowns across several countries could lead to a global slowdown. This potential impact needs to be considered.

Example of growth impact between countries:

 

Note: The EU and China are each others’ largest trading partners.

So let’s put it into perspective, if the EU slows down (which it already has) and stops purchasing goods from China, then China will have less money coming in as a result of exports. China will likely then purchase less natural resources from countries like Australia. (Note: China’s trade with Australia equates to approximately 25% of Australian exports). This will then have an effect on how much Australia can buy (import) from the EU.

This is a great example of how the growth of certain counties is interdependent upon each other.

If Australia’s growth begins to slow down and we see frequent situations of factories closing down and manufacturing being sent offshore due to costs being too high in Australia, then we will be fast tracked to become a service based economy like the US. And the services industry, in most cases as we know, is a non-essential item, and therefore not likely to improve our countries growth where cheaper services provides exist elsewhere across the globe.

The reality of the matter is that these things have already started to happen.

Conclusion

As a trader it is important to be on top of the current events in the markets, not only locally but on a global level as well. It’s not enough to only focus on one element of the bigger picture, when there are many elements that may have an effect on your trading decisions.

Traditionally, most traders have only ever had experience buying or going long in the market (usually stocks), but now it’s ever more important to be aware that markets are two directional, and buy and sell opportunities exist for the astute trader.

However, to be able to trade the markets in both directions requires a good amount of understanding of how the market dynamics work, plus you need confidence in the ability to make the right trading decisions. But that’s another story…

At Trade View Investments we run workshops that provide traders with the necessary understanding and knowledge to take what we have provided in this article and put it into practice.  Our most popular workshop is the Online Systems Building Workshop which is accessible to traders worldwide.

BONUS: Want to find out more?

We’ve provided readers with an excellent video which explains the greater concept of quantitative easing.

This is a must watch for any serious trader.

 


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2 Comments

  • YoungGun November 5, 2013 at 11:57 am Reply

    I’m glad I discovered Trade View, as no doubt you are aware there are not many prop trading firms in Australia that openly share so much info with the public. Back to the article, what do you think the Fed will do over the coming months? And are there any opportunities to benefit from? Thanks!

  • TRADEVIEW November 6, 2013 at 10:25 am Reply

    Hi YoungGun,

    To be honest what concerns me more than the FED tapering is the fact that the economy isn’t really improving and we are getting close to the 7 year market itch. As much as the S&P is up by 23%+ for the year this is not sustainable and is of concern. No Advice, but Trade View is monitoring the situation closely. You may want to look at our article on Pairs Trading to assist with risk management or give us a call to discuss. Thanks for stopping by.
    https://www.tradeview.com.au/introduction-to-pairs-trading/

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