One of the driving forces of the current bull market in risk assets has been the Fed and their very, very, very, very accommodative policies of the past decade+. As we now are set to move into “Taper 2.0,” I thought it would be helpful to put the history of quantitative easing (QE) and tapering, the Fed and the current market expansion in context.
QE was first enacted by the Fed during the Great Financial Crisis when they started buying mortgages and other mostly broken credit products to flood the financial system with liquidity. QE1 happened in 2008/2009 and was about injecting liquidity into the financial system. The Fed stepped up to be the buyer of first and last resort when the fixed income/credit markets completely locked up and froze. And to their credit, they did a pretty good job. QE2 was a whole different beast altogether. In 2011, with short rates already at zero and the US economy struggling to achieve lift-off, the Fed started to once again expand its balance sheet by buying longer-dated Treasuries and longer-dated mortgages. The Fed’s thinking then was “if short rates at zero isn’t helping, maybe getting longer rates lower will help.” After that, QE3 and Operation Twist were variations on the same theme: how can the Fed manipulate longer dated rates (by making them lower) to help fuel economy growth. COVID QE was in reaction to the pandemic. I think the history books will ultimately say QE1 was a resounding success, QE2 less impactful, QE3/Operation Twist didn’t help much at all, and COVID QE is “incomplete.” Along the way, this journey has been an enormous expansion of the Fed’s balance sheet. In 2007, the Fed’s balance sheet was about $800 billion; today that balance sheet stands at more than $8.5 trillion. When you get to be that big, the Fed isn’t just a buyer of bonds. When you are able to manipulate long-dated interest rates and are bigger than everyone else, you ARE the bond market. That’s what I think the Fed is right now.
So now talk turns to tapering the level of the Fed’s monthly bond purchases, the dreaded TAPER 2.0. The Fed will slow their pace of monthly bond purchases and will ultimately try to shrink/reverse the size of their own balance sheet some time down the road. The last time the Fed tapered was 2014/2015, and the equity markets did just fine (lighter blue line in chart below). It’s the line that looks like a flight of stairs in the chart below that is to be watched. That is the Fed hiking Fed fund rates to raise/increase shorter dated interest rates. That is when liquidity comes out of the system. I view the Fed’s first rate hike as more “ceremonial”. It’s the pace of future rate hikes after that that must be watched and monitored.
All economic cycles end the same way: with the Fed hiking rates aggressively and too late and accidently inverting the yield curve (2y rates > 10y rates). When the yield curve inverts NO credit can be created, let alone good credit, and the economy slows over a period of 12-24 months and then stops. I think that phenomenon is years away, but with the Fed now starting to taper I can no longer rightfully call this “early cycle”. In the words of Winston Churchill, Taper 2.0 signals “the end of the beginning”. The commencement of Taper 2.0 means we have moved into “mid cycle.” But “mid cycle” in no way means one should leave this great and glorious bull market for risk assets. Earnings growth is in place and earnings drive the direction of stock prices. Stay on the horse.
TALKINGPoints
Chart data as of November 3, 2021
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