The investors are trying to be prepared for the Fed’s raising the interest rate in late 2015 and 2016, worried about how much it could affect the markets, but they seem to have forgotten what has been supported the markets for several years.
Have we already overcome the termination of the Feds’ QE? The answer is no. Although the interest rates are kept relatively low, and the US stocks remain near the all-time high, the markets are just supported by QEs by Bank of Japan and European Central Bank.
The portfolios of the investors of all kinds have been distorted by the QEs. According to the paper by the Fed, due to the QE the owners of Treasury securities and MBS shifted their funds into riskier assets. For example, the households sold Treasury bonds and MBS to the Fed and bought riskier assets such as corporate bonds, commercial paper and municipal debt and bonds.
Stock markets backed by portfolio rebalancing
This is called portfolio rebalancing, and the portfolio rebalancing is exactly what has supported the US stock markets since 2008. The investors bought corporate bonds because the yields of Treasury bonds were too low, and as the yields of corporate bonds also go down for it, the owners of corporate bonds were also forced to buy even riskier assets, presumably land properties and stocks.
The reverse of portfolio rebalancing
However, the money that has flowed into the stock markets won’t remain there forever. The households bought corporate bonds because the yields of Treasury bonds were too low, and the corporate bonds investors bought stocks instead because the yields of corporate bonds were too low for them.
Then what will happen when the Fed rises the interest rate, and the bond yields are back? They will simply sell stocks and go back to bond markets, as they no longer have a reason to take risks if they can sufficiently earn from bonds.
Therefore, the QE, which accelerated the bull markets, will also accelerate it when the bubble collapses.
When will the bubble collapse?
However, the biggest question is when it comes. Despite my pessimism, I reckon that it won’t happen on the first rate hike, as the Fed promises to rise the rate sufficiently slowly.
Yet, the stock markets might still react to the first rate hike, although it won’t be the real crash as long as the bond yields remain low, even in case the stock markets fall by 20% or 30%. As long as they can’t sufficiently earn from bond yields, they will still wait until they can buy bonds, which is also when they massively sell stocks.
The markets’ reaction will tell you the future
The stock markets’ reaction to the first rate hike will tell you how much further the bubble will go. If the stock markets don’t significantly react to the first rate hike and just go up, the bubble might easily collapse soon, but if a notable correction occurs, possibly by 20% or 30%, the markets will be wrongfully confident that they have overcome the rate hikes, and the bubble could go as far as it wants to go.
Other countries matter
The collapse of the QE bubble could be also delayed depending on when Bank of Japan and European Central Bank terminate their QE. The long-term interest rates of the US are kept low, influenced by the European bond yields, as the US interest rate can’t be too much higher than the Spanish interest rate.
The Fed is also rushing to rise the interest rate, as they must rise it while Japan and Europe are printing money. However, everything will be surely over when both of them finish the QE.
Although I’m not sure whether it is the rate hikes or the terminations of the Japanese and European QEs that actually crash the bubble, the definite benchmark of seriousness is the interest rates.
Even if the stock markets are falling, it’s not the real crash if the interest rates remain low. However, it’s indeed serious if both of the stock markets and the bond markets are simultaneously tumbling. That’s the timing to run away. The epoch-making monetary easing will cause an epoch-making market crash. Get ready, and watch the bond markets carefully.