There’s a saying on Wall Street: “The trend is your friend until it ends.” The trend is still up for the US stock market, which just rallied 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 finally announcing it is ready to begin winding down its latest QE program. The Fed will taper its current $120 billion monthly buying pace by reducing Treasury purchases by $10 billion a month and mortgage-backed securities by $5 billion.
Even though the announcement was widely expected, some traders were surprised by how easily the market shrugged off the news. Here are three reasons fed tapering will not derail this bull market.
#1: QE Is Not Always Bullish
A popular graph that regularly gets shared across 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 was expanding its balance sheet. But what if investors are confusing that correlation with causality?
Quantitative easing (QE) is the process of a central bank expanding its balance sheet to purchase assets such as Treasuries and mortgage-backed securities in the open market.
If QE is bullish for stocks, though, why has Japan’s stock market lagged so much? Japan has done more monetary intervention than any country in the developed world. Yet, the Japanese stock market has significantly trailed the US and Europe.
Since 2000, the Bank of Japan (BOJ) has expanded its balance sheet more aggressively than the Federal Reserve.
Japan started a QE program that included bond purchases in March 2001. Within two years, the BOJ increased its monetary base by approximately 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 enhance the relative return profile of Japanese equities.
One way to test any macro investing thesis is to think globally. If QE was the main bullish catalyst driving the US stock market, it should have been even more bullish for Japan’s market. But in the words of Gertrude Stein, “There is no there there.”
Hence, there is no reason to believe that QE tapering is necessarily bearish for stocks.
#2: Rates Fell During The Last QE Taper
When the Fed buys a lot of bonds, it stimulates bond prices and suppress yields. Thus, it’s easy to see why QE tapering would be bearish for risk assets if you expect interest rates to rise.
But it’s important to also look at how interest rates have actually behaved when the Fed has initiated QE or tapered. Contrary to popular perception, yields have tended to rise during past QE episodes, and fall when the Fed started to taper.
For example, the Fed implemented QE1 from Nov. 25, 2008 to Mar. 31, 2010. During that period, the 10-Year UST rose a total of 72 basis points.
And before the termination of QE 3 on Oct. 29, 2014, the 10-Year US Treasury fell by 57 basis points during the Fed’s taper.
If past is prologue, fears of QE tapering causing higher interest rates appear misplaced. The Fed’s current taper may reignite a bid for treasury bonds, which could result in lower yields. That may have already started at the end of last week, when surging demand for treasuries spurred the largest two-day drop in yields in a year.
#3: QE Is Contractionary
Many associate QE with the word “stimulus,” yet there is more evidence to suggest it is contractionary.
QE stymies loan growth by targeting the long end of the yield curve. The spread between short-term and long-term interest rates determines how profitable lending operations are. By shrinking the spread, monetary officials are shrinking the propensity for lenders to lend.
Ken Fisher spelled this out in a column for RealClearMarkets.com. He wrote, “The Fed deployed three huge QE rounds after 2008’s financial crisis. Lending and official money supply growth shriveled. In the five pre-2008 US expansions, loan growth averaged 8.2% y/y. But from the Fed’s first long-term Treasury purchases in March 2009 to December 2013’s initial taper, loan growth averaged just 0.8% y/y. After tapering nixed the nonsense, it accelerated, averaging 5.8% until COVID lockdowns truncated the expansion.”
Japan’s experience with QE is instructive once again. Japanese banks have been stuck in a very long bear market. Since 2000, Japan’s TOPIX Bank Index has returned -44% compared to +74% for the TOPIX Index and + 285% for the MSCI World Index.
Since QE started in the US, banks have underperformed. Meanwhile, there has been a sharp drop in the velocity of money moving through the US financial system.
Although bank reserves have increased due to QE, banks haven’t been converting a lot of those excess reserves into new loans the private sector can use for expansion purposes. This helps explain why the most recent economic cycle saw the weakest pace of GDP growth since World War II.
QE only played a starring role in one of the last 8 US economic cycles, and that cycle happened to see the weakest growth of the bunch. So, doesn’t it seem silly to fret about QE ending?
To be clear, there are legitimate reasons for investors to be cautious right now. QE tapering just isn’t one of them.
Maybe a bigger risk would be if the Fed stops tapering at some point?