Fed rate stance lifts the appeal of equities

Michael Mackenzie

A stealth bull market rally in US equities that has left many investors behind in recent months now has the additional support of the Federal Reserve and its intention not to tighten rates for the next three years.

It remains to be seen, however, whether the Fed?s efforts in anchoring rates at extremely low levels until the end of 2014 will convince investors sitting on the sidelines to chase the stock market?s gain of more than 20% since October.

The Fed?s ?highly accommodative? policy can be viewed as supportive for certain sectors of the equity market that are boosted by low interest rates and fears of higher inflation in the coming years. This covers utilities, materials, energy and other commodities, particularly gold, which has surged more than $60 an ounce in the past 24 hours, as the dollar weakens.

But a longer period of near zero interest rate policy and the willingness of Ben Bernanke to keep the option of more quantitative easing on the table, highlights the lacklustre recovery of the US economy.

It also illustrates how the eurozone debt crisis and slowing growth in emerging markets loom as key macro risks in 2012, which could ultimately sink equities and boost havens such as Treasuries. That leaves bullish sentiment for stocks a hostage to the tone of upcoming US economic data and events in the eurozone.

?For the Fed?s actions to provide further stimulus to equities, we need to see more upside economic surprises in US data and avoid event-risk headlines,? says Michael Hood, institutional strategist at JPMorgan Asset Management. ?On both of those counts we are sceptical.?

A key threat is a sharp downturn in China and a long recession in the eurozone that eventually weighs on the US and its banks. Several companies, including Dupont, Siemens and United Technologies have in the course of reporting their latest quarterly earnings this month, expressed concerns about slower growth in China.

Indeed after a rise of 1.5 & in the S&P since the Fed?s latest action, the market retreated on January 25, suggesting a degree of caution among investors about chasing the rally. The S&P sits at its highest level since July and is up just under 20% from its low set last October.

?The gain we have seen in stocks since October is important for confidence and gives investors something positive to look at when they open their statements,? says Michael Kastner, principal at Halyard Asset Management.

By keeping rates lower for longer, the Fed is putting more pressure on savers and investors, who have pulled $45 bn out of US equities since last October, to come back to risky assets in the hope of earning a higher return.

?Valuations are attractive and with all the cash on the sidelines and the Fed so accommodative, I think we will see people get back into the market,? says Mr Kastner. But for all the bullishness on equities, the Fed is also providing a boost to a key area of the Treasury bond market, the so-called belly or five to seven-year sector.

With the Fed?s Operation Twist keeping long term Treasury yields anchored, the five-year note dropped to a record low yield of 0.755% on Thursday.

With the Fed on hold for the next three years, investors can confidently buy the sector and be rewarded over the next three years as the five-year note ages and approaches the current two-year yield of 0.2%.

?Keeping rates pinned until late 2014 is clearly positive for intermediate rates,? says Michael Cloherty, head of US rates strategy at RBC Capital Markets. ?Low and stable five-year rates suggest that investors will grab for yield in highly rated assets.? This includes covered bonds and super sovereign debt from the likes of the World Bank and Asian Development Bank, which provide a little more yield over US Treasuries for the next five years.

These type of trades, where money is parked also stands to influence the performance of equities in the coming months, particularly should the Fed embrace QE3.

One key difference in the equity market?s performance since the Fed?s policy meeting has been an improvement in utilities, which have lagged behind other big S&P sectors since October. Materials, seen as proxies for inflation concerns also rallied sharply. Near-zero financing rates for the next three years means it?s more attractive to borrow cheaply and buy higher dividend-paying stocks such as utilities, thus encouraging so-called carry trades. Meanwhile, a weaker dollar and concerns that the Fed will ultimately reflate the economy favours owning materials and also looking at energy.

?It?s not so much the equity market going up, but that two bets, the reflation and carry trades, are back,? says Vadim Zlotnikov, chief market strategist at AllianceBernstein Investments.

? The Financial Times Limited 2012