Quite clearly the last Fed meeting of the year was important. We got the long awaited announcement that the purchase of Treasuries and MBS would be reduced. The rate of 10 billions a month at which it decided to decrease its security purchase was mild enough to demonstrate that the Fed meant to remain accommodative and that its main concerns were the relatively high unemployment rate and the stubbornly low inflation rate, as shown in the word cloud of the Fed Statement.
To put in context how mild this reduction of security purchase by the Fed is, it is worth bearing in mind that US mutual fund holders have been redeeming from bond funds at an average rate of 23 billions a month over the last seven months. This probably supports my contention that the Fed will accept to lag the market shift in asset allocation so as not to send those long term rate flying… but ultimately the 10 year US rate is more likely to trade close to 4% than 2% within the next year or so as private sector redemptions and government withdrawal of liquidity will ineluctably bear on bond valuations. So we will see further steepening in yield curves. The reason behind the price dynamic is clearly driven by growth expectations which are rationalised by the continuous decrease we have observed in US unemployment and general pick up in economic activity. Anyhow it seems that the market took the news very well since we have seen a small upside in equity markets and the VIX has been holding at what once would have been deemed insanely low levels as shown in the below chart.
As of why the VIX remain so low, my theory is that the dynamic is supported by the significant inflows we are seeing in the equity markets. selling short the VIX should indeed correlate with a long position in equity markets. Anyhow the last batch of data has just been released by the ICI and guess what ? It is redemption time again for those fixed income funds. Somehow the Fed meeting which acted as a beacon for the Roubinni’s of this world and black swan watchers proved to be a damp squib because of the modest decrease in security purchase announced. Not surprisingly there were a few outflows for domestic equity funds ahead of the Fed release and the outflows in bonds was as usual negative (as would be consistent with a decrease purchase by the Fed). It is worthwhile noting however that the flows toward global equity funds remained significantly positive. This ultimately lead me to thing that this will put pressure on the US$ particularly against the EURO because of the country weighting in MSCI and other equity benchmarks. Below are the usual map charts and cumulative charts.
As mentioned in the above the inflows into equities and outflows from bond products are taking place in a relatively low risk environment (as expressed by the VIX). I find this interesting as it is consistent with an orderly shift in asset allocation. We are not talking about the kind of asset shift we have seen in 2007/2008. It was then clearly driven by a strong risk adversity and therefore not a long lasting proposition. The chart below illustrates well the new flow dynamic we are experiencing.
This kind of configuration tends to occur when an equity bull markets is taking hold. So my view remain stubbornly unchanged and you are better to get used to the above charts….the bloodbath for bonds has just started it will be slow and agonising…I will stay long equity Beta.