Federal Reserve officials have mapped out a strategy for winding down an unprecedented $85 billion-a-month bond-buying program meant to spur the economy—an effort to preserve flexibility and manage highly unpredictable market expectations.

No doubt the markets will get spooked by this “leak” and as I write these words, ES futures are moderately in the red. The question is, “How much and how far?”

Watch gold for clues to market direction
For me, the canary in the coalmine is the gold price, which is highly sensitive to expectations of monetary stimulus. Gold has staged a tactical V-shaped bottom and the silver/gold ratio has stabilized, which is constructive (see Watching silver for the bottom in gold). Gold rallied to fill in the gap left by its free fall in April – so now what?

With the news that the Fed is starting to think about an exit from QE, the near term downside risk is evident. There are many opinions about the fallout of this “leak”. Josh Brown has two sides of the story. On one hand, he believes that with sentiment excessively bullish, we are tactically headed for a hard correction. On the other hand, he seems more relaxed longer term.

As for myself, I am watching for a re-test of the April lows in gold to see if that low can hold as a sign for the risk-on trade. Longer term, the April decline caused considerable short-term technical damage, but the long-term uptrend remains intact. The other key issue is whether the uptrend can hold here.

A Lost Decade or a “beautiful deleveraging”?
Will this Fed action be a repeat of the Japanese experience where the authorities go through ease-tighten cycles that caused ups and downs in stock prices? This will be a test of Ray Dalio’s beautiful deleveraging thesis where the United States has undertaken just the right mix of austerity, money printing and debt restructuring.

David Merkel wrote a timely post recently entitled Easy In, Hard Out (updated):

My view is that there is no such thing as a free lunch, not even for governments or central banks.  Any action taken may have benefits, but also imposes costs, even if those costs are imposed upon others.  So it is for the Fed.  At the beginning of 2008, they had a small, clean, low duration (less than three years) balance sheet on assets.  Today the asset side of their balance sheet is much larger, long duration (over 6 years), negatively convex, and modestly dirty as a result. 

 He went on to outline the risks [emphasis added]:

Fed tightening cycles often start with a small explosion where short-dated financing for thinly capitalized speculators evaporates, because of the anticipation of higher financing rates. Fed tightening cycles often end with a large explosion, where a large levered asset class that was better financed, was not financed well-enough. Think of commercial property in 1989, the stock market in 2000 (particularly the NASDAQ), or housing/banks in 2008. And yet, that is part of what Fed policy is supposed to do: reveal parts of the economy that are running too hot, so that capital can flow from misallocated areas to areas that are more sound. At present, my suspicion is that we still have more trouble to come in banking sector. Here’s why:

We’ve just been through 4.5 years of Fed funds / Interest on reserves being below 0.5% — this is a far greater period of loose policy than that of 1992-1993 and 2002 to mid-2004 together, and there is no apparent end in sight. This is why I believe that any removal of policy accommodation will prove very difficult. The greater the amount of policy accommodation, the greater the difficulties of removal. Watch the fireworks, if/when they try to remove it. And while you have the opportunity now, take some risk off the table.

Zero Hedge put it more forcefully:

It is possible a steep decline in financial assets would ensue with the lowest part of the capital structure being hurt the most. The Fed has chased investors all in the same direction; into risk-seeking securities. Few care about “right-tail” events, but should investors decide to pare risk in reaction to a hint of ‘tapering’, the overshoot to the downside may surprise many. The combination of too many sellers, too few buyers, and dreadful (and declining) liquidity means a down-side overshoot is highly likely. It would provide the Fed with their answer as to whether they have been creating market bubbles.

It appears that the Federal Reserve is well aware of these risks. In a speech last week, Ben Bernanke said that the Fed was closely monitoring the market for signs of excessive risk appetite, such as reaching for yield [emphasis added]:

We use a variety of models and methods; for example, we use empirical models of default risk and risk premiums to analyze credit spreads in corporate bond markets. These assessments are complemented by other information, including measures of volumes, liquidity, and market functioning, as well as intelligence gleaned from market participants and outside analysts. In light of the current low interest rate environment, we are watching particularly closely for instances of “reaching for yield” and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals. It is worth emphasizing that looking for historically unusual patterns or relationships in asset prices can be useful even if you believe that asset markets are generally efficient in setting prices. For the purpose of safeguarding financial stability, we are less concerned about whether a given asset price is justified in some average sense than in the possibility of a sharp move.

The Fed being aware of a problem is the first step. Whether they can either react, either preemptively or after the fact, in the correct manner is another problem.

I prefer to watch the golden canary in the coalmine to see how the markets react, or over-react to the news that the Fed is mapping out a plan to gradually withdraw from quantitative easing.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.