3 reasons the Fed’s tapering won’t derail the equity bull market
There is a saying on Wall Street: “The trend is your friend until it ends. The trend is still up for the US stock market, which has just rebounded for a fifth consecutive week. The S&P 500 Index is up 16 of the last 18 days; a rare streak that last occurred in 1990.
This week’s gains came on the heels of the Federal Reserve’s announcement that it was finally ready to start cutting its latest quantitative easing program. The Fed will slow its current monthly buying pace of $ 120 billion by cutting Treasury purchases by $ 10 billion per month and mortgage-backed securities by $ 5 billion.
Although the announcement was widely anticipated, some traders were surprised at how easily the market ignored the news. Here are three reasons why powered tapering won’t derail this bull market.
# 1: QE is Not Always bullish
A popular chart that is regularly shared on the Financial Twittersphere compares the growth of the Fed’s balance sheet to the rise of the S&P 500. You don’t need an MBA or CFA to notice the correlation.
Since 2008, the S&P 500 has performed better when the Fed added to its balance sheet. But what if investors mistake this correlation for causation?
Quantitative Easing (QE) is the process by which a central bank expands its balance sheet to purchase assets such as treasury bills and mortgage-backed securities in the open market.
If quantitative easing is bullish for stocks, why has the Japanese stock market dragged so far? Japan has made more monetary interventions than any country in the developed world. Still, the Japanese stock market has significantly followed the United States and Europe.
Since 2000, the Bank of Japan (BOJ) has expanded its balance sheet more aggressively than the Federal Reserve.
Japan launched a quantitative easing program that included bond purchases in March 2001. In two years, the BOJ increased its monetary base by about 60%. Since then, the Bank of Japan has expanded its balance sheet at a faster pace than the US central bank. However, this does not appear to have done much to improve the relative return profile of Japanese stocks.
One way to test any macro investing thesis is to think globally. If QE was the main bullish catalyst for the US stock market, it should have been even more bullish for the Japanese market. But in the words of Gertrude Stein, “There isn’t any there.”
Therefore, there is no reason to believe that declining QE is necessarily bearish for stocks.
# 2: Rates fell during the last phase of QE
When the Fed buys bonds, the goal is to boost bond prices and suppress yields. Some fear that weakening QE could cause interest rates to rise adversely.
However, it is important to look at how interest rates actually behaved when the Fed carried out QE or declined. Contrary to popular perception, yields rose during the last bouts of quantitative easing and fell when the Fed began to contract.
For example, the Fed implemented QE1 from November 25, 2008 to March 31, 2010. During this period, the 10-year Treasury yield increased by 72 basis points.
On the other hand, the 10-year Treasury yield fell 57 basis points as the Fed began to cut at the end of QE3.
If the past is just a prologue, fears of a slowdown in quantitative easing leading to much higher interest rates are misplaced.
# 3: QE is contractual
Many associate EQ with the word “stimulus”, but there is more evidence to suggest that it is contraction.
QE curbs loan growth by targeting the long end of the yield curve. The spread between short-term and long-term interest rates determines the profitability of lending operations. By reducing the spread, the monetary authorities reduce the propensity of lenders to lend.
Ken Fisher explained it in a column for RealClearMarkets.com. He wrote: “The Fed rolled out three huge rounds of quantitative easing after the 2008 financial crisis. Both lending and official money supply weakened. In the five pre-2008 US expansions, loan growth averaged 8.2% year-over-year. But from the Fed’s first purchases of long-term Treasuries in March 2009 to the initial decline in December 2013, loan growth has only averaged 0.8% year-over-year. After decreasing the nonsense, it accelerated, averaging 5.8% until COVID lockdowns truncated the expansion. “
Japan’s experience with QE is again instructive. Japanese banks got stuck in a very long bear market. Since 2000, the TOPIX Bank index of Japan has posted a return of -44% against + 74% for the TOPIX index and + 285% for the MSCI World index.
Since the start of QE in the United States, banks have underperformed. During this time, there has been a sharp decline in the speed of money flow through the US financial system.
Although bank reserves have increased due to QE, banks have not converted much of these excess reserves into new loans that the private sector can use for expansion purposes. This is partly why the most recent economic cycle saw the slowest rate of GDP growth since World War II. It was a long cycle, but not particularly strong.
QE has only played a prominent role in one of the last 8 US business cycles, and that cycle has seen the lowest growth rate of the group. So, doesn’t it seem like a fool to worry about the end of QE?
To be clear, there are legitimate reasons for investors to be cautious at this time. Reducing QE is just not one of them.