Courtesy of Larry Doyle.
I have a commentary running today on MarketWatch that addresses some perils and potential pitfalls stemming from the tapering of the Fed’s quantitative easing.
4 Ways The Fed Taper Puts Your Money at Risk: Don’t Fall Victim to The Fed’s QE Trap
“I don’t know what they are, but I know where they are!”
I had to chuckle when a fellow trader with whom I worked uttered that remark about the markets in which he trafficked. In so many words, he was admitting that he focused almost entirely on daily flows and technical developments within his market sector, while paying little attention to the underlying fundamentals of the securities themselves.
Ignoring fundamentals is dangerous.
Given the high-frequency trading influencing the stock markets and the Federal Reserve’s quantitative easing activity dominating the bond market, investors need to be careful not to get complacent or trapped into making investments under the influence of either of these activities.
The Fed’s tapering of its quantitative easing program assumes a calming corollary — that the central bank will keep rates low for a longer period of time than previously thought. But I would caution investors to remain on guard. Here are a few of the risks that could unsettle investors as the Fed scales back its QE policy:
1. Ongoing lack of liquidity in the inter-dealer market
We witnessed a serious lack of liquidity in late spring 2013 when the concept of tapering was first broached. Little has changed on this front. In fact, do not be surprised if the broker-dealer community provides even less liquidity this year, fighting against an aggressive implementation of the Volcker Rule . Your point of entry into an investment is ever more important in the current environment, where liquidity at the point of exit is increasingly uncertain.
2. A pickup in volatility from historically low levels
The Fed’s quantitative easing has thrown an enormous blanket over volatility VIX -5.82% in the marketplace. The bulls might argue that a tapering of a mere $10 billion per month should be viewed as the equivalent of serving 90-proof spirits rather than the 100-proof stuff that has liquefied the party so far.
While that’s true, markets will often look at marginal moves to ascertain forward prices, not simply absolute levels. From this standpoint, we should be extremely concerned that even a small tapering will cause a move higher in volatility, especially when viewed on a percentage basis. As such, investments that suffer from higher levels of volatility — that is, securities with an embedded short optionality component — should be viewed with a greater degree of caution.
Please read the final 2 traps at MarketWatch that should be avoided as the Fed’s taper slowly but methodically plays out over the coming year.
Navigate accordingly.
