By: Steve Smith
It’s widely acknowledged that the easing monetary policy of Federal Reserve and other Central Banks over the past few years has been a major source of fuel sending stocks and other asset prices higher. It’s also nearly as widely agreed that a sudden rise in interest rates would be a major negative for stocks with the possibility of ending the bull market. Because of these beliefs, the current tightening policies at the Fed might be the biggest investment news of the year.
For now, only the U.S. in in process of increasing rates, and they are also beginning to reduce their balance sheet by not re-investing maturing bonds, a process known as rolling off.
The Federal Reserve is doing this in a very methodical way, a quarter point at a time and a set $10 billion roll off per month. The set pace of the action has caused some label it “Quantitative Tightening,” or QT as opposed to the Quantitive Easing or QE it was engaged in for the past 7 years, until the program ended in late 2014.
There is some debate whether or not this shrinking of the balance will cause rates to rise more than the Fed expects or wants, and in turn cause a major stock market sell-off. In a recent post, the Urban Camel posits that since the end of QE didn’t kill the bull market, the start of QT won’t either.
Here’s an excerpt of his take on this investment news:
Quantitative Easing (QE) ended 3 years ago today. This was widely expected to mark the end to the bull market. Instead, US stocks have risen another 37%.
Why was this view wrong? In truth, the narrative about the Fed’s policy has shifted over time as equities have risen. As late as 2012, QE was viewed as bearish. Into 2014, it was only the continued QE inflows that were considered bullish. When stocks kept rising after QE ended, the narrative shifted to the large Fed “balance sheet” and then to global central bank actions.
The Fed’s policies have clearly led US equities higher, but not in the way that it has been popularly perceived. The Fed established the conditions for fundamental growth in consumption, investment, employment and corporate profits, creating the confidence in investors to place their cash into the financial markets. All of these factors have a strong causal relationship to share price that long pre-date 2009 and the QE programs.
The Fed will now embark on a reduction of its balance sheet (QT). This appears to be the most pivotal event facing markets in 2018. But it stands to reason that so long as the positive fundamental conditions continue, US equities can be expected to remain firm.
None of this implies that the US equity market will continue to appreciate without any interim drama. As noted in the charts that follow, investor sentiment is very bullish and equity valuations are very high. Since 1980, it has been normal for the S&P to correct by an average of 10% during the course of each year of a bull market. With the last correction of that magnitude starting 2 years ago, one of that magnitude, or larger, is arguably overdue in the coming months. That, not the tapering of the Fed’s balance sheet, is the relevant risk for investors to focus on in 2018.
On September 20th, the Fed formally announced that it will begin to reduce its balance sheet, primarily by ceasing reinvestment from maturing bonds. This process is being termed “Quantitative Tightening” (QT) as it is the reverse of the bond buying program known as Quantitative Easing (QE).
QT will begin slowly, with a reduction of just $10b per month during the first 3 months. If there are no major market disruptions, then the pace of QT will be increased by $10b per month every quarter. To put that in perspective, $10b equals 0.2% of the Fed’s total assets. By the end of the year, the Fed’s balance sheet will have been reduced by less than 1% (from JPM). Enlarge any image by clicking on it.
It is a massive understatement to say the Fed’s role in the 9 year bull market is a source of contention. This post examines the Fed’s role in the bull market and the two primary ways QT could affect US equities.
Balance Sheet Reduction
The first way QT could affect US equities is based on the following premise: US equities rose as the Fed’s balance sheet expanded and will therefore fall when the balance sheet is reduced. In other words, the current bull market is mostly a fabrication of the Federal Reserve printing money (QE) and then forcing that money into the stock market.
Behavioralists will quickly recognize that the balance sheet chart as a prime example of “framing.” A recent post on how framing is frequently used to mislead readers is here. A modestly experienced investor knows that stock markets are not driven by a single factor; by presenting only two variables in isolation, the balance sheet chart uses framing to force the reader to make the mental effort to fill in the missing data. The human mind resists making this effort, so it interprets the chart as “what you see is all there is.”
Have stocks risen with the Fed’s actions? Of course. But the correlation implied by the balance sheet chart is much less than it appears. Consider the following:
QE1 was announced in late November 2008. After the first three months, the S&P was 22% lower, a bear market by the most common definition.
The S&P rose 10% during QE2. But it also rose 10% after QE2 ended and before QE3 began, a time during which the Fed’s balance sheet shrank. The S&P rose an impressive 43% during QE3. But it has risen an equally impressive 37% since QE3 ended in October 2014, during which the balance sheet shrank.
The S&P rose about 1,000 points during QE1, 2 and 3 (4 years). The S&P has risen about 700 points between and after the QE programs (which ended 3 years ago).
So the S&P rose during the Fed’s QE programs, but also rose in-between those programs and has risen much more since those programs ended. There were sharp sell offs both during QE and after QE. This is a weak example of correlation and makes a poor case for arguing direct causation.
In fact, the S&P has a better correlation over much longer periods of time with several macro and financial factors, which we will detail in a minute. Note, too, that the S&P has a very high correlation to the average weight of turkeys (r-squared of 96%), an example of how even a good correlation is not proof of causation.