The Federal Reserve poses the biggest threat to the stock market -- but the reason why will surprise you

The biggest threat to stock probably isn’t what you think.

People who believe the Federal Reserve’s asset purchases drove the rally in stocks are dreading higher interest rates.

They argue that higher rates will derail the rally by increasing the cost of borrowing and putting pressure on company’s earnings.

But analysts at Bank of America Merrill Lynch think the impact this will have is overstated and think that, in fact, the Fed doing the opposite of what people are currently anticipating is the biggest risk for stocks.

In a note to clients, BAML’s Savita Subramanian writes that a fourth round of bond buying (or quantitative easing) by the Federal Reserve is, in fact, the biggest threat to stocks:

While most are focused on the risks around a withdrawal of liquidity, we believe the biggest hit to confidence could be the opposite: if another round of US QE is necessary to prop up the economy. While the market could have a knee-jerk rally on an indication of forthcoming stimulus, we think this would likely be short-lived and could end in the red. QE fatigue is already evident: each subsequent round of QE has seen diminishing risk rallies.”

The reason why? It would be a sign that $US4.5 trillion in QE was not enough, Subramanian writes.

And, it won’t look great for central banks in Euro and Japan — which are already in QE-mode — if the US heads in that direction.

Right now, this option isn’t on the bank’s radar, since the third round of quantitative easing has brought the Fed to a point where it has signalled a rise in interest rates this year.

Also, we’ve seen that in fact stocks have rallied in the six months leading up to and after the Fed’s seven rate hikes since 1983.

And so the biggest risk to stocks does not appear imminent. But this risk is also something not many people are talking about.

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