The Federal Reserve is now increasing the outright purchase of longer-duration, federally backed mortgage securities. This is an extension of Operation Twist, whereby the Fed replaced short-term Treasury bills with longer-term Treasury notes and bonds.
In the US, the amount of long duration extracted from the market is now estimated to rise to about $85 billion per month...
Whether all of this is good or bad, we do not know. The extraction from the market of long duration in this amount could lead to a very bullish outlook for the US stock market. We think that is now the case and will remain the case as long as the Fed policy continues in this direction.
Assume that the short-term interest rate is going to be near zero for the next five to ten years. Assume that the long-term interest rate, defined by the ten-year Treasury note, is going to be in the vicinity of two percent for the next five to ten years. What would you then use as an equity-risk premium so you could calculate the value of the US stock market? Let’s run some numbers to try to predict where the market is headed...
[---Interesting calculations, see link---]
Under these assumptions, 1800 on the S&P 500 Index is a fair price today...
Given the above assumptions, the policy broadcast by the Federal Reserve, and the elements that are in place to achieve it...we think it is quite possible that the S&P 500 Index could be closer to 2300, 2400, or 2500 by the end of this decade. As long as Fed policy stays in its present mode, a little more inflation and a little pick-up in the growth rate during the course of the decade will let us easily achieve these numbers.
Will the Fed stay in its present mode for that long? No one knows. Given the current concentration of intensity, effort, and communication on the employment situation in the US, you can easily guess that it will take four to seven years to achieve an unemployment rate low enough to warrant the Fed changing its policy stance...The unemployment rate in the US today is above eight percent. Other employment statistics reveal that the employment situation in the US is not healthy and is not getting better very fast. For US stock market investors, these facts lead to only one conclusion: the bias has to be toward fully diversified investing in US stocks.
---Link. Vitus emphasis
So I am not looking for this new round of unlimited QE to do much more than what its predecessors managed to achieve, which is a feeble and fragile economic environment with very little cushion against an external shock. But can the Fed influence asset prices? The answer is yes for a while. Can the Fed take safe yield and duration out of the private market and as such force investors to replace these "lost" securities with other paper’? Yes it can Portfolio managers will now have to seek out substitutes in areas like non-Agency MBS, CMBS, corporate credit and Munis. And dividend growth and yield strategies within the equity market will see their allure strengthen too. The Fed is focused on asset values driving spending, and it is also clearly trying to generate inflation...Both matter because we have a situation where the Fed has already managed to drive some market-based long-term measures of inflation expectations to nearly 3% while nominal yields are below 1% out to the belly of the Treasury curve and sub-2% out to the 10-year maturity. So what does this mean? It means that real yields are negative and the Fed intends to keep it that way as far as the eye can see.
At the same time, the negative real yield, insofar as it is a discounting mechanism for corporate earnings, effectively boosts the expected future stream of profits and this is likely one reason why the contraction in bottom-line results and poor guidance has failed to make a dent in this market rally. This doesn't mean I am turning bullish — this remains a fat-tail world filled with atypical uncertainties — as much as serves up an explanation for what is going on, Yes, the Fed has changed the goal posts from an investment standpoint. and as such has helped provide a higher floor for the market when periodic corrective phases occur. But if the economy remains stuck in the mud, as I expect, then there is very limited upside from here, in my opinion, outside of the very near-term possibility that lagging hedge fund managers are forced to play some catch-up (one must wonder after the last three sessions how much of this has already played out).