3 Reasons Fed Tapering Won’t Derail the Stock Market

There is a saying on Wall Street: “The trend is your friend until it stops.” The trend is still up for the US stock market, which just rose for the fifth week in a row. The S&P 500 Index is up 16 of the past 18 days; a rare streak that last happened in 1990.

This week’s gains came on the heels of the Federal Reserve finally announcing that it is ready to begin winding down its latest QE program. The Fed will cut its current $120 billion monthly purchase rate by cutting Treasury bills by $10 billion a month and mortgage-backed securities by $5 billion.

While the announcement was widely anticipated, some traders were surprised by how easily the market shook off the news. Here are three reasons Fed tapering won’t derail this bull market.

#1: QE Is Not Always bullish

A popular chart regularly shared in the financial Twitter sphere 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 outperformed when the Fed expanded its balance sheet. But what if investors confuse that correlation with causation?

Quantitative easing (QE) is the process by which a central bank expands its balance sheet to purchase assets such as government bonds and mortgage-backed securities in the open market.

However, if QE is bullish for stocks, why has the Japanese stock market lagged so much? Japan has done more monetary intervention than any other country in the developed world. Still, the Japanese stock market lagged significantly behind the US and Europe.

Since 2000, the Bank of Japan (BOJ) has expanded its balance sheet more aggressively than the Federal Reserve.

Japan started on QE program that included bond purchases in March 2001. Within 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 rate than the US central bank. However, this doesn’t seem to have done much to improve the relative return profile of Japanese stocks.

One way to test a macro-investment dissertation is to think globally. If QE was the main bullish catalyst driving the US stock market, it should have been even more bullish for the Japanese market. But in the words of Gertrude Stein, “There’s none there.”

There is therefore no reason to believe that QE tapering is necessarily bearish for stocks.

#2: Rates fell during the last QE run-down

When the Fed buys bonds, the goal is to boost bond prices and suppress yields. Some worry that QE tapering will hurt interest rates.

However, it is important to look at how interest rates have actually behaved when the Fed has executed or phased out QE. Contrary to popular belief, yields have risen and fallen during previous QE periods as the Fed began to wind down.

For example, the Fed implemented QE1 from November 25, 2008 to March 31, 2010. Over that period, 10-year government bond yields rose 72 basis points.

On the other hand, 10-year Treasury yields fell 57 basis points as the Fed began to wind down at the end of QE3.

If the past is the prologue, fears of a QE winding down leading to much higher interest rates are misplaced.

#3: QE is astringent

Many associate QE with the word “stimulus,” but there is more evidence to suggest that it is astringent.

QE hinders loan growth by targeting the long end of the yield curve. The spread between short-term and long-term interest rates determines how profitable the lending is. By narrowing the spread, monetary officials reduce the propensity of lenders to lend.

Ken Fisher described this in a column for RealClearMarkets.com. He wrote: “The Fed launched three massive rounds of QE after the 2008 financial crisis. Lending and the growth of the official money supply shrank. In the five US expansions prior to 2008, loan growth averaged 8.2% year on year. But from the Fed’s first long-term Treasury purchases in March 2009 to its initial winding down in December 2013, loan growth averaged just 0.8% year-on-year. After phasing out the nonsense, it accelerated, averaging 5.8% until COVID lockdowns truncated expansion.”

Japan’s experiences with QE are again instructive. Japanese banks are stuck in a very long bear market. Since 2000, the Japanese TOPIX Bank Index has returned -44%, compared to +74% for the TOPIX Index and +285% for the MSCI World Index.

Banks have underperformed since the start of QE in the US. Meanwhile, the velocity of money flowing through the US financial system has fallen sharply.

Although bank reserves have increased as a result of QE, banks have not converted much of those excess reserves into new loans for the private sector to use for expansion purposes. This is partly why the most recent economic cycle saw the weakest GDP growth rate since World War II. It was a long cycle, but not particularly strong.

QE has only featured in one of the last 8 economic cycles in the US, and that cycle happened to have the weakest growth of the bunch. So, doesn’t it seem silly to worry about the end of QE?

To be clear, there are legitimate reasons for investors to exercise caution now. QE tapering is not one of them.