The stock market may drop by 10 percent or more now that the Federal Reserve’s debt holdings started shrinking again after its last stimulus program ended, said broker-dealer Cantor Fitzgerald & Co.
Before January, the central bank’s holdings of U.S. Treasurys and mortgage debt had rocketed
to more than $4.5 trillion in six years as the Fed purchased bonds in an effort to press interest rates to record lows. The three rounds of “quantitative easing” were intended to encourage spending, punish saving and help the economy recover from the worst slowdown since the Great Depression.
The stock market slumped by more than 10 percent after the Fed's stimulus programs ended as the economy showed signs of weakness without the central bank’s monetary crutch. That may happen again this year after the Fed ended the latest round of QE in October, according to Cantor.
The Fed’s “balance sheet began to contract in mid-January for the first time since February 2012,” Peter Cecchini, chief market strategist at New York-based Cantor, said in an April 13 commentary
to institutional clients. “In each instance of even modest contraction, the U.S. equity markets experienced a considerable pickup in volatility.”
QE and More QE
He pointed to the S&P 500’s 15 percent drop after the first quantitative easing program, which doubled the Fed’s bond holdings to more than $2 trillion, ended in March 2010. The market recovered as the Fed, headed by Chairman Ben S. Bernanke
, made plans for a second QE program to buy $600 billion of Treasurys.
After that program ended, the central bank’s balance sheet leveled off and the market sank by 17 percent. In 2011, the Fed started a program dubbed Operation Twist to exchange short-term debt for long-term bonds. The market recovered and the Fed’s debt holdings remained steady.
Stocks later sank by 9.8 percent in mid-2012, and the Fed began a third round of quantitative easing to buy $40 billion a month of mortgage-backed securities. It expanded that program to $85 billion a month by buying more Treasury debt. QE3 ended in October as unemployment continued to fall and the economy showed signs of sustainable growth.
The Fed's debt holdings are declining as they reach maturity, and that may foreshadow a stock market correction, or a drop of 10 percent.
“The size of QE3 dwarfed QE2,” Cecchini said. “The implications are, as we have been discussing, negative for U.S. large caps (as well as U.S. equities in general), especially in light of what we believe will continue to be a stronger dollar.”
The U.S. dollar has gotten more valuable in relation to other currencies as central banks in Europe and Asia print more money to stimulate their ailing economies. A stronger dollar has negative effects on U.S. companies doing business overseas.
“We continue to believe the strong dollar will be a principal mechanism for the transmission of volatility to U.S. large caps and emerging market equities,” Cecchini said. “We don’t become more bearish until we see corporate default rates begin to pick up outside the energy sector.”
In possibly another negative signal for stocks, the relationship between the Chicago Board Options Exchange’s three-month volatility index, the VXV, and its 30-day volatility index, the VIX, reached a key level, according to CNBC
The business news channel cited research from Bank of America Merrill Lynch technical analyst MacNeil Curry.
Curry said Thursday's and Friday's closes "above 1.2 in the VXV/VIX ratio
is a significant concern. Historically, the market has struggled to hold its gains when this ratio closes above 1.2."
Curry said that a VXV/VIX ratio below 1 is a buy signal for the S&P 500, according to CNBC.
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