Vince Foster: The Fed's QE Reflation Trade Is Unwinding One Asset at a Time
Neither Fed members nor Wall Street analysts are sounding any alarms, but they should be.
For the past few weeks I've focused on two main themes that were contrary to the consensus: that equity risk was due to rise and that long-term interest rates were due to fall. Both of these themes have indeed played out recently -- and investors shouldn't underestimate what these trends portend. They're both the same trade.
In the equity market, the thesis was predicated on a shift in upward momentum that threatened what was previously a parabolic advance with little consolidation of prices. In Technical Indicators Now Point to Significant Downside Risk, I pointed to big levels in the high-beta indices, Nasdaq 100 (INDEXNASDAQ:NDX) and Russell 2000 (INDEXRUSSELL:RUT) that, if violated, pointed to a material decline in values.
In the bond market, the thesis was predicated on a reduction in the inflation risk premium in the yield curve, which would anchor a flattening bias, pressuring investors into extending duration. In Why Long-Term Interest Rates Are Falling and May Continue to Drop, I noted that there was potentially a classic pain unfolding and that the 3.50% yield on the long bond was a critical pivot.
On Friday, the NDX closed down 1.6% to close at 3533, and the RUT closed down 1.86% at 1123 -- both right on top of the key pivots I cited. The 30-year long bond yield settled at 3.44%, the lowest level since July. Despite this risk-reduction bias, the sentiment remains sanguine. However, I believe these markets are talking, and they're saying the same thing. As the Fed removes accommodation, the asset reflation they engineered is deflating.
Nowhere is this asset deflation more evident than in the markets that were directly targeted by QE: housing and mortgage lending. In the February edition of the Black Knight (formerly Lender Processing Services) Mortgage Monitor, analysts noted that mortgage originations had dropped an astounding 65% year-over-year, reaching a record low. New mortgage originations were down 22% month-over-month, and down 47% year-to-date.
With home sales and lending softening during the winter months, there has been anticipation of a springtime rebound in activity. Last week the consensus for March monthly new-home sales growth was for a gain of 2.3%, following a decline of 3.3% in February. The number came in at an astonishingly negative 14.5%, with February revised to a decline of 4.5%. Mortgage applications dropped 3.3% on the week, with purchases falling 2.6% and refis falling 3.7%. The share of applications for refinance fell to 51.3% of the total, down from 80% when QE 3 began in 2012.
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It doesn't take a Wall Street strategist or Federal Reserve economist to understand what's going on here, yet neither seems to be sounding the alarm. The Fed's QE reflation trade is unwinding, and it would be naive to think it's going to be confined to the housing and mortgage market. In fact, we're seeing signs across the asset market spectrum -- from commodities, the dollar, and the yield curve.
We saw similar price action in 2011 when the Fed ceased QE 2 cold turkey. As the markets began sensing an end to the program, the reflation trade slowly rolled over, seemingly one asset at a time, with a climax during the August stock market mini-crash. You only need to look at the correlation between beta performance (Russell 2000/S&P 500) and the slope of the yield curve (five year/10 year) back in 2011 to understand how markets react to a removal of accommodation. Just because this time around stocks have remained near their highs doesn't mean that they're immune from a similar fate. In fact, we're starting to see signs that beta relative performance is once again following curve flattening.
We're halfway through earnings season, and so far we've seen a majority of companies beat earnings estimates. But if you look under the surface, the growth rate tells a different story. According to FactSet, the earnings growth rate for the quarter is just 0.2% on revenue growth of 2.4%. A 3.5%, 30-year risk-free Treasury doesn't look so expensive considering these measly growth rates, and it could be the catalyst for the bid for duration. The fact is, equity investors don't own growth; they own multiple expansion, which has occurred on the back of the Fed's reflation. Investors own multiples that are on the high side of history and that are eliciting a flurry of dubious IPOs and private equity-backed exits. The saying goes "They don't ring a bell at the top," but you might say there is one ringing.
The Fed's QE reflation is coming out of the currency market, bond market, mortgage market, and housing market -- and there's no reason to think it won't come out of the stock market. Beta is underperforming in a big way, just like it did when QE 2 ended, and I think that's a major red flag. The equity market sits at a critical juncture, and the fast money has its finger on the trigger. Sentiment is unusually sanguine about the market, despite what are clear signs that the Fed's QE reflation trade is unwinding. As we approach the summer months, investors should at best prepare for subpar returns -- and at worst, a severe repricing of risk premiums.
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