The buzz in the media over the past year has been focused on the upcoming Fed taper. How useful is Fed asset buying as a signal for a change in the prospects for stocks? After all, the Fed constantly performs open market operations, and the market participants on the other side of the trade are equally good at playing the Fed's next market move for economic gain. Usually broader market measures to understand the impact of Fed policy on the stock market are better suited for the job. The most obvious indicator is the movement of interest rates, which in a due course are always inversely correlated in relative measure to asset value. This statement is true even in today's rate controlled Treasury market.
But the "taper" is the market focus, and therefore, understanding how the market has historically reacted when the Fed slows asset purchases, or reduced the size of its balance sheet is useful information for investors. More useful, it seems, because the Fed has interjected itself so forcefully into the market for financial assets since September of 2008, and also steadfastly held to a policy of zero-bound Treasury rates.
To create an understanding of how a change in direction of Fed policy impacts the stock market, I dug into the data dating back to FDR and WWII through the present day. The data is captured in two graphs which follow in this article. Both graphs capture the yearly rate of change in the Fed balance sheet holdings of U.S. Treasuries and other assets such as Mortgage Backed Securities, adjusted for inflation. The timing of historical stock market corrections are overlaid on each graph. Two distinct periods were analyzed - WWII through the early 1970s, and 1971 until the present day.
Tapering Relative to Stocks - 1941 through 1970
The graph below shows the rate of change in the Fed balance sheet from 1941 until the early 1970s. This period has distinct characteristics that are important for investors to remember. One, the debt to GDP ratio in the U.S. was over 100% following WWII, and it slowly decreased in percentage to a low point of less than 35% relative to GDP in the early and mid 1970s before reversing direction. The country borrowed over $200B to finance WWII. When the War ended, President Truman cut government spending dramatically and balanced the Federal budget. In support of the government fiscal policy, the Fed throughout the 1940s utilized a "zero bound" interest rate policy. Similar to the Fed policy since 2008, the Fed and the U.S. Treasury coordinated policy to keep rates paid on Treasury securities low for "an extended period". The extended period in the 1940s lasted until 1951 when the Treasury-Fed Accord was reached in Eisenhower's administration allowing the Fed to regain some of its independence in setting interest rates.
Another characteristic of the time period was that it was a period of rising interest rates, most pronounced beginning in the latter half of the 1950s to the 1960s. During the late 1940s the U.S. ran surpluses in foreign trade, and international exchange rates were based on the Bretton Woods Accord. The Accord backed every U.S. dollar in international trade with gold, exchangeable at $35 per ounce. This system worked wonderfully until the U.S. began importing more than it exported. As the trade situation changed in the 1960s, driven by the Vietnam War and Great Society based programs, the Bretton Woods system for foreign exchange became unmanageable and was abandoned by Nixon in August 1971.
Looking at the graph, the historical context provides a rational which explains Federal Reserve open market operations. You can follow the change in comparative size of the Fed balance sheet by focusing on the green shaded area on the graph. The change in the Fed balance sheet, on a relative scale, grew substantially in the early 1940s. Looking back, the $24B in Fed purchases of Treasuries appears miniscule; but, relative to the U.S. GDP of $200B it was significant. The decline in Fed balance sheet purchases as 1946 approached, and the subsequent decline in growth of the Fed balance sheet reflect the Truman budget taking effect and a cessation of Fed asset purchases. However, the Fed balance sheet remained fairly stable at about 10% of Treasuries outstanding during the time period. What happened, and is visible in the graph, is that inflation was rampant in the 1946 and 1947 time period, which created a "tapering" effect as the value of the assets on the Fed's balance sheet shrunk in relative terms.
The impact on the stock market from the taper in 1946 was immediate and a 20% market correction peak to trough was recorded. The red shaded area in the graph shows the time in which stock investors with perfect knowledge of the circumstances would have chosen to have sold stocks, and not re-enter the market until the very end of the decade. The decline in the 1946 "tapering" episode was relatively mild by comparison to the declines registered in more recent market corrections - 1974, 1981, 2001, and 2008. The U.S. economy in 1946, although buried in debt, had substantial tailwinds from foreign demand for goods. The May 1946 euphoric top in the stock market, followed by a sharp correction appears to have been arrested by expectations for rising real GDP growth - probably not coincidentally, this set of circumstances is precisely what the current Fed is hoping for before changing the present day policy.
The remainder of the graph from 1950 through 1970 reflects a different mode of operation for the Federal Reserve. Since the Federal government turned the corner and put the U.S. debt on course for a steady decline relative to GDP, the demands from the government on the Fed to "peg" interest rates lessened in the 1950s. The major decline in the Fed balance sheet in the early 1950s reflects an actual reduction in absolute dollars in Treasury holdings by the Fed. In so doing, government fiscal spending and Fed policy simultaneously became restrictive economically, and eventually the Fed had to reverse course and inject reserves back into the system in 1952 - but not before the stock market exhibited declines. In general, however, the early 1950 monetary policy actions of the Fed did not instigate large market corrections.
During the 1960s Fed balance sheet management began to affect the U.S. economy in a new way. The 1960s is known in Fed history as the "even keel" policy time period. The period is marked by growing federal deficit spending. Although the U.S. debt relative to GDP was declining, the government appetite for spending was growing. In order to finance the increasing spending levels, the Fed would enter the market and buy Treasuries from banks in the Federal Reserve System. This action would free up lending capacity in the monetary system to absorb the new Treasury offering at the lowest possible rate. After the financing round was complete, the Fed was expected to re-enter the market and sell the Treasuries it had accumulated in order to assist the Treasury. However, political pressure grew to keep interest rates low even after the offering was completed. The Fed began to bow to the pressure by not selling assets from its balance sheet, instead holding on to the Treasuries - in other words the Fed was perpetually using quantitative easing to finance government spending. As the graph shows, throughout the 1960s, the Fed balance sheet began to grow in relative terms. And, the growth was accompanied by increasing inflation rates. By the end of the 1960s, when the Fed implemented a "tapering" of the growth rate in its balance sheet, the impact on the stock market became more immediate, and also more dramatic. (See the yellow arrow labeled taper on the graph). In November of 1968 the S&P500 end of month close was 108. In June of 1970 the market bottomed at 73, a painful, drawn-out decline of 32.4% over a 19 month period.
Tapering and Stock Returns - 1971 through 2013
Moving on to the early 1970s, a historic monetary move was made by the U.S. in August of 1971 - the abandonment of the gold standard for international trade transactions. Between June 1970 and December of 1972 the stock market rallied to 118 on the S&P 500, a 62% increase from its lows. The market rally transpired during, in my professional opinion, one of the worse economic policy decisions in modern history. The Fed, at the behest of Nixon economic policy, began to increase money supply through quantitative easing in an effort to achieve a 4.5% unemployment rate target. The Phillips Curve economic guiding principle suggests that there is a trade-off between unemployment and inflation. Unfortunately, the correlation between the unemployment rate and money supply growth is very poor. In fact, over the long-term it is more apt to be inversely correlated as inflation takes hold on the economy, as Milton Friedman's academic research so accurately reflects.
Targeting the unemployment rate through quantitative easing was an abysmal failure in the early 1970s. The unemployment rate actually increased as Nixon vied for a second term in the White House. Meanwhile the value of the U.S. dollar, driven by the high rate of domestic inflation, suffered a major set-back. From June 1970 to June 1973 the Real Dollar Index (DXY) declined from 121 to 95, a 22% decline. Throughout this time period, the Fed continued to steadily and aggressively accumulate Treasury securities. The green shaded area on the graph below appears small because it is inflation adjusted. The absolute value of every dollar purchased by the Fed was losing value at an increasing rate.
Eventually the excessively easy Fed policy in support of the U.S. fiscal policy had to be "tapered" in response to the weak dollar. The most visible and well remembered symbol of the economic side effects of this policy was the Arab Oil Embargo. Since the end of 1973 until the present day, OPEC and the relative price of oil has become the only consistent tempering force on excessive Fed quantitative easing policies.
The graph above shows the Fed open market operation actions from early 1970 through October of 2013. The major, long lasting market corrections were all preceded by a reduction in Federal Reserve purchasing activity. Included in this category are 1974, 1981, 2001 and 2008. The other four time periods were also preceded by reductions in Fed purchases, but the impacts were not as severe. As you can see in the graph, periods such as the late 1970s and the end of the 1980s were marked by reductions in the Fed balance sheet in relative size, not just a slowdown Treasury purchases. In these instances, the level of interest rates on U.S. Treasuries increased, and as many investors can still recall, the late 1970s produced double digit yields in on Treasury securities of all maturities. In contrast to the high rate time periods, in 1994-95 the Fed was in the process of tapering and the stock market was on the verge of falling, only to recovery into the era of "Irrational Exuberance" as Fed entered with more quantitative easing. Which came first, the easy money, or the exuberance?
The timing of stock market corrections as the Fed tapers asset purchases does not follow a predictable script - at least not one that I have been able to model with accuracy. Fed tightening of monetary policy is a necessary ingredient for a major market correction, but there are other contributing forces which need to align to trigger a market downfall. The most common element in the major historical declines is the reaction to foreign trade imbalances, usually exhibited by a spike in oil prices. The subsequent need for the Fed to lower its rate of asset accumulation, allowing the interest rate structure to increase is historically a more accurate signal from a timing standpoint.
The Present Fed Dilemma
Having experienced two major stock market declines in 2001 and 2008 triggered to some degree by relatively more stringent monetary policy, the Bernanke and soon to be Janet Yellen led Fed seems intent upon making the next episode different. The question is whether the Fed has absolute power over stock market reactions to its policy. History shows that monetary policy has its limitations, and therein lays the present dilemma.
The growth in the Fed balance sheet in 2008 is historically matched in relative magnitude only to the change during WWII. From my analysis, the similarity on a relative basis is almost eerily so. The prologue introducing the new Fed Chairman Ben Bernanke to the world in 2006 as a scholar of the Depression seems in retrospect to be a very apt precursor to the job he was going to face in 2008, and the manner in which he executed Fed policy in response. Probably not as a surprise, the Fed policy to the liquidity crisis in 2007 and 2008 was a massive injection of reserves into the system. The more interesting observation when you view the Bernanke policy actions from a balance sheet perspective is that the Fed was "tapering" until the 2008 crisis was in full panic mode, and then the $1.2T in TARP financing was unleashed after Lehman Brothers went bankrupt. The crisis management reaction by the Fed led to the Keynesian based zero bound interest rate policy that followed, and the $1T plus QE program being executed in 2013.
In order to keep the Fed Funds target near zero when nominal economic growth is above zero, an ever increasing level of quantitative easing is required. The liquidity injected into the monetary system comes back to the Fed as excess reserves. To extinguish the extremely high level of reserves being injected into the banking system in 2013 so they are not inflationary, there are two very important restrictive policies which are holding the framework together. One, the banking system is being put under higher and higher capital standards for "risky" assets. The latest stress test requires the "too big to fail" banks to withstand a 50% drop in the stock market. The choice of 50% is probably not a coincidence, since a drop of this magnitude is very likely fair value for the market in a no growth economy minus the excessive Fed balance sheet. By pushing these requirements through the system, the Fed lowers the expansionary capacity of the excess reserves in the banking system as the money multiplier becomes more muted because the banks will not make risky loans. The result of the restrictions is that the excess reserves are parked at the Fed and collect .25%. If this reserve rate was actually pushed down to 0.0%, the system is likely to unravel - I do not expect the rate to be lowered any time soon, but there are some inquisitive members of the Senate Banking Committee that pressed Janet Yellen on this issue in recent Fed testimony by asking whether the reserve rate should be taken to 0%.
The second market action governing inflation is the unexpected recent restraint in government spending growth. The lack of growth in fiscal expenditures since Obama's initial $1T increase in the budget in 2009 is historic in its constraint. In fact, it has not happened since 1946 - although it must be said that the 1946 reductions were true scale-backs in spending. The Obama budgets are currently maintaining spending at the higher levels put in place after 2009, and in recent months have begun to trend up again. Historically inflation correlates significantly with high rates of government spending increases and high levels of Fed quantitative easing. However, the U.S. fiscal and monetary policies are currently on different pages when it comes to sparking consumer price inflation. The prior statement is not to say that inflation does not exist. Excessive Fed monetary action "always and everywhere" creates too much money chasing too few assets. Presently, the monetary ease is increasingly flowing through to the stock market, much like it did in the late 1960s and early 1970s. The accommodation to the stock market is not an unusual outcome; the graphs provided in this article reflect that during times of easy money, stocks rise. What is unusual is the high degree of correlation between the stock prices and QE, particularly since the beginning of 2011.
The dilemma for the Fed is that its credibility is being tested by extreme policy actions from which the successful withdrawal requires low probability events to take place. Successful reduction of the U.S. debt relative to the U.S. economy in the 1940s was fostered by high employment and a current account surplus. Presently, the fiscal policy of the country is pulling in a diametrically opposite direction, and Fed policy, at least in historical review, is not the cure.
Watch Risky Credit Spreads for Signs of Trouble
As I stated at the beginning of this article, I do not believe that actual Fed tapering actions or statements about tapering will signal a stock market correction with accuracy for investors. Janet Yellen reiterated in testimony to the Senate Banking Committee on November 14th that the Fed has no intention of reducing asset purchases until economic growth is sufficient or inflation becomes a problem. I think investors can take the Fed at its word on this statement - there will be no problem until there is a problem. What the Fed has said in its attempt to be transparent is obvious. If nominal economic growth picks up, the Fed will taper, but not reduce its balance sheet. If real growth is the reason for the taper, then stocks will have a support level from continual Fed support. If growth is led by inflation, the break-down in the market will be more immediate and severe like the early 1970s, most likely because the Fed will have to reduce the size of its balance sheet involuntarily, or else inflation will spiral.
In spite of $85B a month in asset purchases in April through August of 2013, interest rates on the long-end of the curve increased. Janet Yellen in her testimony repeatedly pointed to lower long-term rates as the reason unemployment is currently falling. Somehow, the facts are not lining up with the assertion as the opposite is now taking place in the market for credit. Interest rates on riskier credit assets such as municipal bonds (MUB) (SHM) (PZA), preferred stock (PFF) (PGX) (PSK) and long-term utility bonds I track continue to trend higher, and are increasing more relative to Treasuries (TLT) (TLH). The risk spread between real economic activity based long duration bonds and rate controlled government bonds is where investors need to pay attention at the present time. The market for riskier credit calmed in October as the government shut-down injected the prospect that rates would not move higher. But in the recent week, rates on the long end began to tick up again.
My own view at present is that long-term interest rates on risk assets cannot move much higher without a stock correction taking place. However, I do not see the signals that I look for to trigger an immediate major downturn, meaning that the stock market momentum trade higher is likely to continue over the near term. However, signs are brewing that there is trouble ahead and the downturn will be significantly more painful because stocks are trading up in anticipation of an unlikely outcome. The trading pattern in the transition from 2013 to 2014 is likely to be very telling with regard to the true underlying belief in the current market valuation (SPY) (DOW).