Although it may seem a bit premature, given the Fed’s rhetoric about keeping its current monetary policy for the foreseeable future, some investors are already fretting the Fed slowing its quantitative easing (QE) bond purchases—aka tapering. Renewing 2013 fears, they worry it will stall the economic recovery and upend the stock market. As we will explain, we don’t think that is likely. But we do see a widely ignored longer-term risk tied to tapering: an economy that overheats rather than implodes.
To understand today’s taper fears, it helps to understand QE. The Bank of Japan implemented the first QE program in 2001, which ran until 2006. Major central banks adopted it during 2008–2009’s global financial crisis. Under QE, central bankers create reserves and buy massive amounts of long-term bonds and other assets from banks. This fills banks with capital. Also, because bond prices and yields move inversely, buying long-term bonds lowers long-term interest rates. The Fed and others argue this spurs loan demand by reducing borrowing costs, offering cheap financing for growth-enhancing investment and spending. Many also believe QE drives investors from low-yielding bonds to stocks—boosting prices.
From September 2008—right before the Fed began QE—to when it ended in October 2014, the Fed’s balance sheet expanded from $900 billion to $4.5 trillion. [i] It then stayed there—with the Fed buying only to replace maturing bonds—until 2017. Thereafter, the Fed let its balance sheet shrink at a slow, steady rate. But amid last March’s lockdown-driven crisis, the Fed restarted QE. Its balance sheet has subsequently swelled from $4.3 trillion to $7.4 trillion as of February.[ii] Many credit this expansion with calming and resurrecting markets.
But QE doesn’t do what people think it does. With the Fed pinning short rates near zero, QE forces long rates down, too—flattening the yield curve. The yield curve is a proxy for banks’ loan profitability. Banks borrow at short rates and lend at long rates, profiting from the difference. When the yield curve steepens, lending is more profitable for banks, giving them more incentive to extend credit—especially to riskier borrowers, like many small businesses. But a flatter yield curve gives banks less incentive to lend. Riskier borrowers struggle to access credit. The result: slower loan growth and less money moving through the economy, hamstringing expansion. Wherever central banks have tried QE, be it in the US, UK, Japan or eurozone, it has never worked as advertised.[iii] In all, lending and GDP grew slowly.[iv]
By the same token, there is no evidence tapering QE hurts GDP or stocks. On May 22, 2013, the Fed hinted at reducing its bond purchases, triggering the so-called Taper Tantrum. From then through December 18—when it officially announced it would begin tapering—10-year Treasury bond yields rose from 2.0% to 2.9%, steepening the yield curve. [v] During this stretch, the S&P 500 rose 10.7%.[vi] The Fed tapered for most of 2014, before concluding the program. Loan growth accelerated in 2014 as the Fed ceased QE altogether in October. GDP growth sped from 1.8% in 2013 to 2.5% in 2014.[vii] The S&P 500 climbed another 13.7%.[viii]
The UK and eurozone experienced similar results. In November 2012, the Bank of England stopped QE. UK loan growth picked up and GDP accelerated. When the European Central Bank tapered in 2016 and then halted its QE in December 2018, eurozone lending accelerated and GDP chugged higher. In all cases, tapering and QE’s end weren’t the negatives so many feared. The point they missed: Ending QE led to a steeper yield curve, an overlooked economic positive.
Although a steeper yield curve is an economic positive, given sentiment is broadly optimistic now, we think there is a risk that it leads to overheating, which few appreciate. Money supply exploded last year due largely to the Fed’s “relief” efforts, but the velocity of money—i.e., how quickly money changes hands economywide—sank to record lows. If the Fed tapers and the yield curve steepens, that may spur lending. Money could start circulating faster in the economy. As velocity accelerates, inflation heats up. Too much money chasing limited amounts of goods and services could launch price indexes upward.
Now, we don’t think this is a given, let alone probable, today. While central bank actions aren’t predictable, the Fed hasn’t given any indication it is about to taper. But even if it did taper today without any warning, the yield curve would likely have to steepen considerably before any loan growth boost. That usually takes time. Inflation wouldn’t leap overnight, much less get out of control. That said, we think a scenario like this is a risk worth monitoring closely.
For now, we don’t think investors should get hung up on bubbling taper talk. Chatter about what the Fed will or won’t do isn’t a reliable guide to any actions it might take.
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[i] Source: Federal Reserve Bank of St. Louis, as of 02/16/2021. Total Federal Reserve assets, September 2008–October 2014.
[ii] Ibid. Total Federal Reserve assets, March 2020–February 2021.
[iii] “Did Quantitative Easing Help Spur Growth?,” Erik Norland, CME Group, 08/09/2018.
[iv] Source: FactSet, as of 02/16/2021. Statement based on total loan and GDP growth during QE for Japan (2001–2006), US (2008–2014), UK (2009–2014) and eurozone (2009–2018).
[v] Ibid. 10-year US Treasury constant maturity yield, 05/22/2013–12/18/2013.
[vi] Ibid. S&P 500 total return, 05/22/2013–12/18/2013.
[vii] Source: Federal Reserve Bank of St. Louis, as of 02/16/2021. Real GDP, annual, 2013–2014.
[viii] Source: FactSet, as of 02/16/2021. S&P 500 total return, 12/31/2013–12/31/2014.
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