- Conventional wisdom says that the Fed’s taper is bearish for bonds and stocks.
- In fact, the taper is bullish for stocks and bonds.
- Falling bond yields do not signal higher bond yields.
The common wisdom for understanding the behavior of the capital market since the Crash: "The Fed launched QE in order to artificially depress bond yields, resulting in the lowest bond yields in modern history. The tapering, ending and reversal of QE will remove this source of artificial demand, resulting in higher bond yields. The stock market has also been propped up by QE and will decline once this stimulus is withdrawn."
The common wisdom, however, is untrue. The intended (if unspoken) purpose of QE was to lower the real funds rate by raising inflation expectations. Money printing is inflationary and raises expected inflation and thus bond yields. The withdrawal of QE is inherently deflationary and should lower inflation expectations and bond yields.
In his famous deflation speeches, Bernanke provided excellent explanations of the need to raise expected inflation in order to lower the real funds rate. In a nutshell: the real funds rate is the nominal rate minus expected inflation. To stimulate the economy requires a negative funds rate. When the nominal rate is zero, the only way to make it negative is by raising the expected rate of inflation. This is what Bernanke was trying to do with QE. He was ultimately able to get the real funds rate down to minus 2%, which was stimulative (but inadequate and too late).
The tapering of monetary stimulus has resulted in lower bond yields. When the Fed began to taper in January, the 10-year bond yielded 3%. Now, eight months into the taper, the 10-year yields 2.4%, a decline of 20%. In January, TLT was at 102; today it is at 118. Bond prices have risen during the taper, and continue to rise. This is because when the Fed shuts down its printing press at the end of this year and then begins to reverse QE, the impact on money growth should be negative. It's true that QE did little to goose money growth, but its ending and reversal are unlikely to be stimulative. Depending on which monetary aggregate one chooses, the Fed has been tightening since 2012 (M2) or since January (MB). Tighter money, lower inflation, higher bond prices.
This discussion is not only relevant to the bond market; it is also crucial for equity valuation. There are now two schools of thought with respect to the level of stock prices: the CAPE school (bearish) and the ERP school (bullish). The CAPE school says that PE ratios are too high, while the ERP school says that today's high PEs are justified by low bond yields. The CAPE fraternity says that today's low interest rates are artificial and should be ignored in the calculation of expected equity returns. They argue that there is no rational justification for today's elevated multiples. Once the Fed withdraws QE, bond yields will normalize and stock prices will fall. If they are right--if bonds yield rise--then the CAPE school would be vindicated. But that is not happening.
The equity valuation argument hinges on the outlook for bond yields (and inflation). In my view, falling bond yields provide conclusive evidence that the market does not expect higher bond yields. The evidence to date suggests that bond yields are already normalized and that the elevated equity premium will persist until stock prices rise to much higher levels.
Let me elaborate on why I don't expect higher bond yields or higher inflation. The reason that I do not expect higher bond yields (besides the fact that the bond market doesn't) is that the Fed has begun to tighten in the face of slack labor market conditions, below-target inflation, and subpar economic growth. The Fed has over-estimated the strength of the economy and is running from an inflation risk that doesn't exist.
The broad unemployment/underemployment rate (U-6) was 8% before the Crash; today it is 50% higher at 12%. The civilian unemployment rate was 4.2% before the Crash; today it is 50% higher at 6.2%. Core PCE inflation is now 1.5%, which is 25% below target (YoY). Nominal growth (YoY) following the 2002 recession was as high as 7.2% and real growth was as high as 4.4%. Today nominal growth is a low 4.2% and real growth is a subnormal 2.5%. The economy remains in second gear and is vulnerable to a negative demand shock. Bond yields are falling because the Fed is in the process of making a series of unfortunate mistakes, as it did in 1937-38.
The taper has resulted in higher bond and stock prices. The end and eventual reversal of QE should provide further support.
QE: quantitative monetary easing via the Fed's purchase of government and mortgage securities.
TLT: an exchange-traded fund which seeks to track the investment results of the Barclays U.S. 20+ Year Treasury Bond Index.
M2: the measure of the money supply used by the Fed and most economists.
MB: the monetary base, which approximates the size of the Fed's balance sheet.
CAPE: Robert Shiller's cyclically-adjusted price earnings ratio which uses 10 years of inflation-adjusted earnings rather than 12 months as in the trailing PE.
ERP: the equity risk premium which measures the difference between the expected return from stocks versus government bonds.
Additional disclosure: Iam long stocks and bonds.