Introduction – the Fed wants to take back some of that which it has given
In planning to do what it thinks is right for the economy and the general health of the financial system, the Fed is strongly contemplating the greatest monetary tightening ever. I went somewhat ballistic when the Fed performed QE 3 (2013-14), but it did it, and the financial markets and economy have adjusted to its consequences. Now, the Fed is talking about reversing it completely. I proved the correlation of both stock and bond bull moves and QE 3 and caught on both to what was happening and what would probably happen by December 2013 and February 2014, as shown by the hyper-linked articles. Now, it may that the virtuous cycle of higher stock market valuations being followed by higher bond valuations (i.e. lower interest rates) is in danger of being reversed (i.e., normalized). “Normalization” is something that the Fed has been talking about for a long time, at least since head of the New York Fed, Dr. William Dudley, said the following in a major speech on December 1, 2014 (emphasis added):
The third implication that stems from the fact that financial market conditions matter in the conduct of monetary policy pertains to the so-called “Fed put” with respect to equity prices. The notion here is that because the Federal Reserve cares about unanticipated and undesired changes in financial market conditions, the Fed will respond to weakness in equity prices by easing monetary policy – essentially providing a put to equity investors. The expectation of such a put is dangerous because if investors believe it exists they will view the equity market as less risky. This will cause investors to push equity market values higher, increasing the likelihood of an equity market bubble and, when such a bubble bursts, the potential for a sharp shock that could threaten financial stability and the economy.
Let me be clear, there is no Fed equity market put. To put it another way, we do not care about the level of equity prices, or bond yields or credit spreads per se. Instead, we focus on how financial market conditions influence the transmission of monetary policy to the real economy. At times, a large decline in equity prices will not be problematic for achieving our goals. For example, economic conditions may warrant a tightening of financial market conditions. If this happens mainly via the channel of equity price weakness – that is not a problem, as it does not conflict with our objectives.
This is clear and emphatic, and the Fed now feels this is the right time economically, financially, and politically to press on with normalization. The most recent FOMC minutes showed that the Fed believes that stock prices are significantly elevated, though not in a bubble, and it sees the uptrend and wants to avoid a bubble, as the closing sentence of the first paragraph makes explicit.
Normalization – the numbers
The audited annual report of the Fed for 2007 showed that its assets were $873 B and $915 B at the end of 2006 and 2007, respectively. The growth rate in 2007 was 4.8%.
Today, per the Fed’s May 25 H.4.1 report, this number grew to $4.52 T. That’s about an 18.5% increase. Let’s say over time, this number has grown about 6%, which is the rate of nominal GDP growth since 1929. This represents massive “stimulus,” also called money printing. If one subtracts the $2.22 T that are excess reserves, bringing adjusted Fed assets to $2.3 T, the CAGR of Fed assets since the end of 2007 is still a very high 10.2%. However, there’s no reason to do that subtraction. Almost all the $3.6 T balance sheet expansion since 2007 entered the financial system.
Per the successor to Fed Chair Janet Yellen as president of the San Francisco Fed, John Williams, in a recent interview with Bloomberg TV, the Fed is looking to bring excess reserves down to about $300 B or by nearly $2 T. If one ignores growth of the economy, that would bring the Fed’s balance sheet to $2.6 T. Counting in growth, then I’m going to use $3 T as the terminal balance sheet after a proposed five-year program. That would mean about a $300 B, or $25 B per month, “quantitative tightening” program may begin in Q4 of this year.
Before discussing what this might mean for investors, let’s look at the Bloomberg News article summarizing the interview with Dr. Williams.
Why is the Fed planning quantitative tightening?
The May 29 piece is titled Fed’s Williams Sees ‘Much Smaller’ Balance Sheet in Five Years. Here are some excerpts, with emphasis added, and my commentary interspersed:
Federal Reserve Bank of San Francisco President John Williams sees a “much smaller” Fed balance sheet in about five years, at the end of an unwinding process that could start with a “baby step” later this year.
“How big will the balance sheet be five years from now, when this has all happened?” Williams said in a Bloomberg TV interview with Haslinda Amin in Singapore on Monday. “That is something we haven’t decided on. It will be much smaller than today.”
The politics of this are interesting. Just as Ben Bernanke committed his successor, Janet Yellen, to a taper of QE 3 in 2014, beginning quantitative tightening (my term, to be sure) this year sets a precedent that may require a hurdle or two such as recession to be reached before discontinuing that policy.
The interview spent most of its time on other matters. Dr. Williams supported the idea that the Fed will raise rates two more times this year, presumably at the next June meeting and then in September. Quoting from near the end of the article:
“The economy is doing well, with good momentum,” he said… “We have a way to go on inflation goals but I am optimistic about the economy.”
The policy tightening aims to avoid letting the economy run “too hot for too long,” Williams added.
Are we really at risk of an overheating economy? This is discussed in the next two sections.
Risks to investors from the Fed’s plan – big picture
The Fed is planning to stop QE 1.5 completely or in large part. This may have been, quietly, the largest of all the QEs. It was begun after QE had ended and when the Fed did not expect a second one, thus it was not called QE 1 as it is now. What we now call QE 1 ended in March 2010, though it took until June, I believe, for all the Fed’s bond purchases to settle, so from a money flow perspective, it ended in the latter part of Q2. All of a sudden, markets and economic indicators turned down sharply. So much for “recovery summer,” as Obama administration economists had projected, and so much for an easy exit from the Great Recession. In response, the Fed acted quickly and, in early August 2010, began what it promoted as a bridge to QE 2. This program consisted not of monetary expansion, as full-blown QE was, but also of a refusal to let the balance sheet shrink. The Fed accomplished this by “printing” new money “out of thin air” when income came in, typically at that point from mortgage bond principal paydowns, but also if Treasuries in its portfolio matured. After QE 2 began in Q4 2010 and ended in June 2011, markets sold off again, and the Fed gave up hope of ending QE 1.5. In its press release after every FOMC meeting since then, the Fed puts a comment in about continuing reinvestment of maturing bonds. The Fed chose this wording on this topic from the recent May 3 meeting:
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.
Ending this policy will help reverse accommodative financial conditions. Meaning tighter money. Meaning the mortgage and Federal debt issuance that the Fed has indirectly been monetizing to the tune of hundreds of billions of dollars a year (my estimate) via QE 1.5 is going to end of shrink.
So, that’s one headwind to asset price valuations.
The other is the micro, namely – dude, where’s my overheating?
Risks to investors – micro view
In its second estimate of Q1 GDP, the BEA reported the following summary data:
- real GDP – annual growth rate of 1.2%
- current dollar GDP – annual growth rate of 3.4%
- inflation around 2.5%.
The inflation rate was increased by the yoy changes in crude oil prices, of which a reversal in trend is almost fully baked in the cake.
Since 2007, meaning the last peak year before the Great Recession, GDP has risen from $14.5 T to $18.6 T. That’s a CAGR of 2.8%. Over the past five years, 2011-6, GDP has risen at a 3.7% rate. (Data from FRED.)
Over the past year, reported GDP rose from $18.04 T to $18.57 T, a 2.94% rate. Remember, these are nominal GDP growth numbers. They look like the real GDP growth numbers from the 1950s and 1960s, and again the good years in the 1980s and 1990s, but no such luck. That’s what slow population growth and modest productivity growth rates will do.
So, where’s the overheating?
Does anyone remember 1937?
Concluding remarks – how much of a threat to stock prices (and bonds) is the Fed?
Shrinking the money supply affects real economic performance. It also reduces the fuel that powers stock prices. It is designed to make money scarcer, or in the Fed’s view, to put the financial system on a diet after years of being force-fed by QE. The ongoing QE process, including both QE 1.5 and the lingering effects of all the money created by the Fed since 2009, has pushed the S&P 500 (NYSEARCA:SPY) to much higher levels than where it was when the profits of the companies in the index first reached current levels (mid-2014), or when national profits as measured by the BEA in its NIPA accounts first reached current levels (2011). Thus, there’s a lot of P/E (and other valuation) reduction that could occur if excess reserves were brought down by almost $2 T. In addition, just think of how much of the Fed’s trillions of dollars of Treasury and mortgage bond securities owned mature each year, and then think of $300-400 B of that new money no longer entering the bond market to purchase new mortgage and Federal debt. Something’s going to give, and it’s going to be economic performance, in my view.
Banks are lending again. Earnings estimates for such core parts of the economy as Union Pacific (NYSE:UNP), United Technologies (NYSE:UTX), Deere (NYSE:DE), and Caterpillar (NYSE:CAT) are rising. Q1 was the first in some time in which earnings did not disappoint as reporting season began and progressed – a good sign. So, it’s a “what’s not to like” situation for equities.
But the business upturn after the 2015-6 slowdown is young. The Fed, understandably, fears stagflation, and it fears yet another 1999-type stock market bubble. Over the long run, this may be just the right thing to do. In the shorter run, meaning this year, this is just what speculators hate. Some readers may remember that I turned bearish on the SPY in a mid-December 2015 article, and that bearishness was based on a combination of a sluggish economy and a Fed that was determined to raise rates.
I would look at the possibility of a Fed error again in thinking of stock prices and the Fed’s preferred plans as laid out methodically and in a matter-of-fact manner by Dr. Williams. When the Fed is hawkish, fighting that 2.5% or so inflation rate and talking about overheating, focused on a 4.5% of so unemployment rate rather than looking at the depressed employment:population ratio, history suggests over and over that margin traders will reduce their leverage. There are lots of traders who own long bonds with leverage, as well. As the Fed continues to push short rates up, seeing a good economy and motivated by the goal to normalize policy sooner rather than later, more car buyers get priced out of the market. The same holds true for home buyers. So, to be a little sarcastic, does the growth come from the app economy?
No, not really, because Facebook (NASDAQ:FB) and the Google subsidiary of Alphabet (NASDAQ:GOOGL) (NASDAQ:GOOG) make their money from advertising real goods and services. The free stuff is like old-fashioned “free” TV, paid for by producers of stuff that costs money to buy.
Investors the past eight years have largely benefited from a one-way trade. If the economic news was disappointing, the “Fed put” was in play. If the economic news was good, then good news was indeed good for share prices. Now that dynamic is – palpably – in danger of being turned around 180 degrees. If Janet Yellen’s successor at the S.F. Fed can worry in public that 3 1/2% nominal GDP growth and a low rate of employment of working age people mean that the Fed should focus on the economy running “too hot,” then good news for the economy may well be bad news for stock prices.
What would deter the Fed from shrinking the money supply big time as Dr. Williams predicts will occur?
Bad news on the economy would do it, which would be better for bonds and bond funds such as the popular unleveraged iShares long T-bond fund or (NYSEARCA:TLT) or the more volatile and less well-known PIMCO zero coupon long T-bond fund (NYSEARCA:ZROZ); and worse for stocks.
Thus, I think the Fed poses headwinds for stock valuations. Taken in conjunction with typical summer seasonal patterns, a sinking spell for stock prices would be a reasonable occurrence. After all, we saw such an event almost every summer from 1995 to 2000, when the markets were soaring.
Saying all that, of course, there are other factors influencing stocks. The economy could, in fact, accelerate and overcome monetary counter-cyclical factors. The Fed could threaten all it wants, but the President gets to nominate a new Fed chair early next year, and that person could take an alternative point of view that would be more friendly to the markets: standing pat. After all, growth is moderate; inflation is moderate. Why not just let growth plus inflation gradually diminish excess reserves at their own pace? That would be much friendlier to investors and their (our) long positions, I would think.
Looked at very broadly, the Fed has been “easy” from late 2008 to late 2014, when QE 3 ended. That “ease” expanded its balance sheet, roughly equal to the base money supply, by about a 25% CAGR by the time QE 3 ended in Q4 2014. Since monetary policy acts with a lag of approximately one year, in a sense, it’s been easy until it raised rates at the end of 2015. It is more hawkish now that it has been in quite some time, possibly more hawkish in relation to actual economic fundamentals since its tightening in Y2K, 17 years ago. It took several interest rate hikes in 1999 and 2000 for investors to give up on Internet stocks. It took 17 rate hikes from 2004 to 2006 for the housing bubble to pop. So, we shall just have to see what the Fed does and how traders react month to month this year and next.
Over the very long term, the Fed is a creature of government, and the US government loves to point to high stock prices as a sign of its brilliance and/or beneficence, or at least basic competence. So, a very big picture view of things involves looking for ways to participate in that government-approved goal of a “strong” stock market.
It’s going to be interesting to see how this “take away the punch bowl” mindset of the Fed and resultant psychology of traders fit in with the current bull market view that stock prices are still too low in relation to today’s interest rates. Given the fact that stock and long T-bond total returns have jointly advanced by about 12% per year over the past six years, I cannot view the secular bond bull market as unthreatened by the Fed. What the Fed has created, it may wish to uncreate, or “normalize.” And, this could occur to stocks and bonds.
Interesting investment times, indeed.
Thanks for reading and sharing any comments you may wish to provide.
Disclosure: I am/we are long DE,UTX,UNP,TLT,ZROZ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not investment advice. I am not an investment adviser.