The Fed’s hand is hovering over the wide open tap. The U.S. central bank may cautiously begin to ease its $85 billion monthly dose of quantitative easing. The gold bubble has burst in anticipation. The line of other losers could be long. With less liquidity from the Fed, bonds, commodities and stocks are likely to be hit – probably in that order.
The dollar is the agent of change. Money printing devalued the greenback and beefed up many markets, above all gold. Now the index of the dollar against major trading partners is close to its highest since July 2010. The yen, the euro and the previously rampant Australian dollar are weakening as U.S. bond yields offer new buyers a fraction more.
The yield on 10-year U.S. Treasuries is just short of 2 percent and close to its highest for two months. The Fed’s monthly purchases of Treasury bonds has kept it down but the chances that the Fed will trim its ambitions are growing. The timing and scale of the tightening remain uncertain but the strengthening recovery suggests that bond yields could rise further. Bond investors might avoid a crash, but a long bear market may already be beginning.
Commodities also look vulnerable, even though prices have trailed behind equities. The Thomson Reuters CRB index is down 2 percent in the year to date while the U.S. S&P 500 stock index is up by 18 percent. Commodities’ divergence from stocks reflects in part a rising dollar, in which commodities are priced. Supply may be improving too, notably in North American oil production. And yet with Brent crude at $104 per barrel, oil remains highly priced by most historical norms. There may be further commodity downside as the QE tap tightens.
For equities that’s mostly good news, promising cheaper raw materials and fuel for growth. Corporate earnings are also lubricated by modest wage growth and still-low interest rates.
Hopes for renewed growth have made equities the world’s favourite bet this year, though investors have also been attracted by the relatively low equity valuations. However, if the Fed tap tightens and bond yields and medium-term interest rates rise it is unlikely that even equities will get off scot free. At least some of their recent strength should be seen as QE froth. When the tap has been gushing for so long, even a slight change may have the capacity to shock.