The Market’s Many Reactions to the FOMC Meeting

On Thursday, Janet Yellen had an important meeting about the Fed’s monetary policy and the future of the QE taper, which is likely to continue at its present pace until the Fed is no longer buying bonds at the beginning of 2015.

Also significant was her statement that the Fed may increase interest rates six months after ending the QE program—meaning that interest rates on Treasuries would begin to rise earlier than the market had expected (late 2015). This hawkish sentiment from a Fed chairman famous for being dovish caught many investors by surprise, resulting in a number of bear markets worldwide.

So how did the markets react? Let’s look at them one by one.

Bonds

Already falling, long-term bonds fell further after the announcement as investors feared the value of bonds was doomed in early 2015, so it was time to offload now, as we see from looking at the long-term Treasury ETF TLT:

Since bond yields rise when bond prices fall, a rise in the Fed target rate would cause the value of the bonds to decline. Anticipating this, investors sold off Wednesday afternoon with significantly higher volumes than earlier in the day.

On Thursday, bonds recovered slightly as some speculators saw oversold Treasuries and others look for a safe haven amidst a moribund unemployment rate and greater geopolitical threats as the Crimea crisis carries on.

Gold

Gold did even worse, as we can see from the SPDR gold ETF GLD:

Again the volatility spike at the end of the day—but why would people sell gold if a Fed interest rate rise would cause inflation, which benefits gold? The reason is that the risk/reward profile of holding gold in this environment is more skewed towards risk than reward. Earlier in 2014, hedge funds were broadly bullish on gold, but the conviction was by no means as strong as in 2013, when some traders earned as much as 10x on their capital by shorting gold. This year, however, a Fed taper and interest-rate hike could actually cause disinflation or stagnant inflation at best, if interest rate hikes cause people to spend less and buy less. Hence gold would be less of a safe haven and more of a money pit.

Volatility

Volatility, on the other hand, did exceedingly well, as we can see from the VIX:

That spike at the end of the day follows Yellen’s Q&A session, in which investors began to fret that the Federal Reserve’s movements were going to hurt stocks more and more. Yellen cannot be blamed for this, however; back in December the Federal Reserve said quite clearly that they wanted to introduce more volatility into the market. They have done that, with 13.5 being a new absolute bottom for the VIX in 2014.

Global Stocks

After U.S. markets closed, the Hang Seng fell by almost 1.8%, the Nikkei 225 by 1.65%, and the Kospi by 0.94%. The FTSE 100 fell by 0.49%, the Dax by 0.29%, and the CAC 40 ended up 0.01%. The more muted European response is as unsurprising as is the extreme Asian response; while Europe’s slow growth and geopolitical concerns remain concerns, the situation has improved considerably in recent months. The soft landing in China, however, has proven disappointing, and even Japan’s robust QE policy is not helping the country’s wages as much as it is causing higher prices, leading to concerns that aggregate demand is set to disappoint throughout the east. As a result, bears on Asia have hit the Hang Seng hard, which is down nearly 10% in the last 6 months.

U.S. Equities

The most immediate and intense reaction to Yellen, by far, remained stateside, where stocks fell off a cliff on the meeting, after beginning the day on a slightly sour note:

Interestingly, both large caps (DIA) and small caps (IWM) fared much worse than the broader market (SPY). This can be interpreted in many ways, but all inevitably point back to the concern that recent stock prices have risen not because earnings have improved and will continue to improve, but because there is just more money in the system. The S&P P/E ratio has hovered between 19.50 and 19.90 for most of 2014, which is much higher than the historical mean but still not above 20, which is when most recent major crashes have occurred.

It’s difficult to make a strong case that stocks are extremely overvalued now or in a bubble, but it’s even harder to make the case that stocks are very cheap. The result is uncertainty (causing the VIX to rise) but neither irrational fear or exuberance, causing stocks to remain mostly horizontal. And this is exactly what we have seen so far for 2014: the fear of spikes in volatility but the reality of extremely range-bond price action. These are frustrating markets for short-term traders, but a moment of welcoming calm for long-term investors. Most importantly, it is also a transition to a world where valuations matter much more and changes in the monetary base mean much less, so investors need to do much more research and due diligence before throwing money at the market.