The Federal Reserve has started to talk about removing extraordinary accommodation. Market expectations are building for the reduction in stimulus to begin in September with the forward guidance to come out of the Jackson Hole conference. Likely, they will first reduce support for mortgage-backed securities. They have been buying $40 billion per month and $80 billion of treasuries. They have stopped some other support programs recently. They stopped support for corporate bonds, though they never really had to buy much, just say that they would. They have increased yields for excess reserves (IEOR) 5 basis points to a still low 15 basis points.

In 2013, their talk about removing QE stimulus caused interest rate sensitive markets some stress. The US 10-year yield moved from about 1.65 to 3.00 per cent over a relatively short period. The Fed walked back rate hike risk over the next few years and they did not actually start to raise rates for about 2 years (Dec 2015). They started to raise rates more regularly in 2017 and 2018 (Dec 2016 – Dec 2018) where expectations of “Trump” stimulus efforts released animal spirits.

The stress to equity market valuation started in 2015 as the size of the Fed’s balance sheet started to shrink as a percentage of GDP. This probably starts by the first quarter of 2022. The next stress to equity market came after the “Trump” tax package was passed and deficits exploded in 2018. There were 2 corrections in the 10 per cent plus range. The second correction was closer to 20 per cent and the Federal Reserve had to stop rising rates and eventually increasing their balance sheet by Q3 2019.

The set up now is much more reliant on low rates to support valuations. More than in 2015 and in 2018. The size of the (QE) stimulus as a per cent of GDP is significantly higher. This suggests that when equity markets begin to sense the support backing away, we can expect higher equity market volatility. A move to 3.00 percent for US 10-year yields and a similar reduction in the Fed balance sheet over the next few years could easily see the S&P 500 drop back towards the mid 3000s. If the S&P 500 can earn 210 in 2022 like analysts currently expect, a 16.5 long-term multiple offers valuation support around 3500. So look for some of the froth to come off, but also for corrections to be supported.

Make sure you check out our weekly update in our PRO-EYES macro indicators each week to help figure out when it’s time to be cautious or when it’s time to be opportunistic.

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