Don't Fight the Fed (Especially When They're Throwing a $600 Billion Party!) — Bond Market Analysis , Stock Market — GCC Market Analytics
Don't Fight the Fed (Especially When They're Throwing a $600 Billion Party!) | GCC Market Analytics

Saturday, 18 December 2010

Don't Fight the Fed (Especially When They're Throwing a $600 Billion Party!)

Below is an interesting chart I came across on the Quantifiable Edges blog.  It shows the S&P 500 Index (green line) along with the 20-day running total of the Fed's POMO activity (red line).

Fed POMO Activity and Stock Market Action
[ Click to enlarge ]
What's POMO? Quantifiable Edges explains:
For those unaware POMO stands for Permanent Open Market Operations and it is how the Fed goes into the open market to buy (or sell) treasury securities. The net effect of this buying is an influx of cash into the system. It appears a portion of that cash makes its way through the banking system and into the stock market. It also appears that the net effect of all this Fed buying is a positive influence on the stock market. Conversely, when the Fed sells securities in the open market then it is pulling money from the system. This appears to have a possible negative influence on the stock market.
As the chart shows, the current level of treasury purchases by the Fed is on a par with the purchases made in response to the market meltdown in 2008. The high levels of POMO activity during 2008 and 2009 was the result of the first round of quantitative easing and corresponded with an explosive turnaround in the stock market.

We're now in the midst of the second round of quantitative easing (QE2).  QE2 will amount to $600 billion and is scheduled to last until June next year.  As with QE1, QE2 has so far been positive for the US stock market and with another six months of Fed stimulus yet to go that could carry over well into 2011.

This looks like a case of "don't fight the Fed." Of course, there are many reasons to be bearish on stocks right now (high valuations, European debt crisis, high unemployment, little sign of a turnaround in the US housing market, etc) but if the Fed is intent on throwing a party it probably isn't a good idea to trade against them.


P.S.  One potential problem to a continued stock market rally are rising yields.  The primary aim of QE2 is to keep long term interest rates at low levels.  However, as noted in a previous post, yields on 10 year US treasuries have risen significantly over the past couple of months, despite the Fed's purchasing activity.  Has the bond market realised something that the stock market hasn't?