According to our U.S. Bond Strategy service, there could be some modest disruption in the performance of risk assets as the Fed pares back its asset purchases.
One key question about Fed policy is whether quantitative easing works through the portfolio balance channel (i.e. the stock view) or whether it is the pace of purchases that matter (the flow view). Another is whether asset purchases matter at all or whether it is simply the implicit guidance associated with quantitative easing that has served to ease monetary conditions.
At this point, it is too early to confirm which mechanism is at work, but we can confirm that the expansion of the Fed’s balance sheet did coincide with abnormal depression of the term premium deep into negative territory. The compressed term premium has helped to support the market for spread product.
The above table shows the returns for various assets during the three episodes of quantitative easing to date. In almost every case, asset returns were greater in weeks when the Fed was buying more than the median amount of securities, and lower when it was buying less.
These results suggest that some modest disruption in credit spreads is possible as the Fed embarks on tapering its asset purchase program. Reduced market liquidity could exacerbate volatility in the near run. Nevertheless, corporate fundamentals remain strong and accommodative monetary policy means that the search for yield will remain intact for another couple of years at least.
Article courtesy of http://bcaresearch.com