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).

[ 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.

Enjoy.

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?

Keep an Eye on the Bond Markets

Despite the S&P 500 Index making new recovery highs the real action at the moment is in the bond market.

Bonds tend to get less attention than stocks even though the global bond market is $82 trillion versus about $45 trillion for global equity markets.  Also, the bond market is arguably more influential on the stock market than the other way around.  Which, if you're bullish about the future prospects of stocks, makes the current goings on in the bond market a bit worrying.

You've probably already heard about the European debt crisis. Here's what it looks like from the perspective of the bond market:

The charts above show the 10 year bond yields for Spain, Portugal, Ireland and Greece.  The so called PIGS.  Think of the yield as the interest these countries must pay in order to borrow money.

As you can see, yields have risen sharply for these countries.  Greece and Ireland have already received financial aid but this has done little to bring down borrowing rates for those countries.  In fact, the current yield on Greek bonds is now back to levels seen just before the country's bailout in the spring.

Despite the bailouts the bond market is essentially predicting the both Greece and Ireland will eventually have to restructure their debt obligations (a.k.a. default).  The same goes for Spain and Portugal which, as yet, haven't required financial assistance.

Portugal could be bailed out in the manner of Greece and Ireland but Spain is a problem.  The Spanish economy is twice as big as the Greece, Ireland and Portugal combined.  Which poses the serious question: is Spain too big to bail?

The whole point of sovereign bailouts was to stop the spread of the debt crisis to other countries. Has that worked?

Well, it doesn't look like it.  As the charts above show, the yields on Italian, Belgium and even French and German debt have risen sharply over the past couple of months. Which makes sense because as each country is bailed out the remaining Euro zone countries take on their debts.  So, rising French and German bond yields are simply a reflection that those countries have taken on the debt obligations of Greece and Ireland as well and Spain and Portugal in the not too distant future.

The problem is not just contained within Europe either.  Check out the recent jump in US 10 year treasuries:

And this is despite the Fed's current $600 billion spending spree, the primary aim of which was to keep yields at their previously historic low levels. That jump in yields doesn't translate into good news for the US housing market.

Conclusion

Bond market yields are pricing in something nasty.  Of course, that could turn out to be wrong.  But the bond market hasn't been wrong so far and if they're right about the future stock markets will eventually have to play catch up.  My advice: keep and eye on bond markets. That's where the front line of the ongoing financial crisis is at the moment. Here are the relevant links to the charts above:

Greece - Ireland - Spain - Portugal - Italy - Belgium - France - German - USA - UK

Enjoy.