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Paratrade Systems Weekly Research News

26 Aug

How much help can we expect from the Fed?

There seems to an obsession with the Fed as if their willingness to lower rates is all we have to think about. If they are dovish then we can hold equities without fear. We must hold long bonds since zero yield at the short end of the yield curve is useless when it comes to offsetting liabilities.

What’s clear (at least to us) is that the Fed has been worried about the stock market since the debacle of 2008. For lack of another gauge to track global solvency, the Fed has decided to provide the S&P 500 with whatever fuel it has needed since collapsing equity prices can often create liquidity vacuums.

The problem we have today is the S&P is at or near record highs so how much help can we expect to get? Let’s start by looking at how well bonds do when stock prices are high. In a period of flat bond prices we would expect negative returns but we have a very skewed 15 year history. That means we have a good sample to work with. Either because of economic trauma, falling inflation, or Quantitative Easing, the Fed has bought bonds or lowered rates rather consistently. We can see below that when the S&P was up, however, bonds did much more poorly:

Fed Blog1

Over the period 52 points were made by only holding bonds when the S&P was below its 50 day average. Outside of those periods, an additional 22 points were earned which proves how aggressive the Fed was. Even when the S&P was rising bonds, still went up!

The same results appear when filtering for closeness to the recent highs.

The question becomes – What happens to Risk Parity (stocks + bonds, volatility weighted) under these conditions?

FedBlog2

As we can see, almost three quarters of the performance of Risk Parity is earned when the S&P is below its highs by at least 2%. If the S&P runs up and sets new highs, bond losses will offset those gains.When the stock market is running up, the Fed offers little (or less) help and/or investors don’t expect it to continue easing as aggressively. This includes periods where inflationary conditions were benign and the Fed had committed to a QE program that they could only retract slowly. Bond prices rallied consistently over the entire sample period.
Going forward, we are unlikely to see such dis-inflationary forces because the unemployment rate has fallen so much. Significant rallies in the S&P may well hurt bonds even more than in the past and that will not be good for RP.

The S&P is currently less than 2% below its most recent high. That doesn’t bode well for bonds since they can’t can’t count on the Fed to save them. We hope that the extremely low foreign yields continue to force foreign buyers into US treasuries. That should cap out price declines unless inflation takes off.

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