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Monday, June 02, 2014

A Very Visible Hand

Last December when then Fed Chairman Bernanke announced the first tapering of the QE by reducing the monthly purchase of 85 billion in government securities by 10 billion per month, the following historical event immediately came into my mind: mid-2004, when the Fed started exiting the “extremely low” rate (1%) program that was designed to help the equity market after the internet bubble burst, and the September 11 attack.  Once the tightening started, the Fed acted like clockwork by raising the rate exactly 25 bps in every FOMC meeting, 17 times in a row, until the rate reached the “normal” level of 5.25%.  See Figure 1.

My prediction drawn from this event?  The fed will do exactly the same thing this time, tapering by 10bn in each meeting until totally exiting the QE program.  Any deviation from such a clockwork pace will cause disruption or even turmoil in the market with the public second-guessing the intention of the Fed.

So far, we are right on the money – the two FOMC meetings after the initial December taper did exactly 10 billion each time.  Investors should hope that Yellen does not venture off course here.

Figure 1.  Fed fund rate from 2003 to 2008.

Since 2000, the Fed has been playing a bigger and bigger role in the global markets, especially the equity market.  Investors chew on every single word in the FOMC minutes.  The “full employment” mandate and the association of interest rate with employment rate – a theory that somehow became an academic orthodoxy and undisputed truth   encourage the Fed to wield the Fed Fund Rate as a universal weapon on solving any economic problem.

Look at the Fed Fund Rate history since 1989 (Figure 2), which was the beginning of this bull run that lasted over 20 years, the “norm” of rate was around 5% -- which makes the recent near 0% rate period so extraordinary in this historical perspective.  The visible and powerful hand of the Fed, with the short term rate as the main weapon (and together with its unlimited balance sheet that supports its QE programs), now becomes the most important macro-force in the equity market that overwrites the statistical aspect of the traditional invisible hands.

Figure 2.  Fed fund rate from 1989 to 2014.

Whether one agrees with the Fed’s policy or not, the powerful visible hand of the Fed should be the most important factor for market participants like us to consider.  “Don’t fight the Fed!” that’s the financial analogy of Buckminster Fuller’s “Don’t fight forces, use them”.  Several observations can be drawn here: 1.  Correlation in the market will continue to be high as long as Fed is the main driving force (even though the breakdown of some high momentum stocks in recent days was a slight deviation of this trend);  2.  Volatility will remain low, with intermittent spikes, caused by trivial things such as Yellen’s slip during a speech; 3.  The interest rate is abnormally low, but sooner or later, there will be a reversion to normal interest rate regime.

 Derek Wang, CEO, Bell Curve Capital LP - dwang at

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