The mood on Wall Street can change in the blink of an eye. Nothing demonstrates this better than what happened on Wednesday, Dec. 18 following the Federal Reserve's announcement that it would "modestly reduce the pace of its asset purchases." The long-awaited and long-feared tapering will begin in January.
We all knew that tapering had to start sometime. It was only a question of when. The consensus view was that the Fed would wait until March. That was my view as well. I have been a proponent for ending quantitative easing sooner rather than later and I have argued that the Fed made a big mistake when it led the market to believe that it would start tapering last summer, but then failed to follow through. However, since Bernanke's term ends soon (Jan. 31), I was convinced that he would hold off a little longer and allow Janet Yellen to make the decision to reduce QE.
As a result, I was a little surprised with the Fed's announcement on Wednesday that tapering will begin in January. I was surprised much more by the market's reaction. I was convinced that the market was so prepared to absorb a modest amount of tapering that we could expect nothing more than a muted reaction. On the contrary, after an initial selloff on the news, stocks spiked violently higher. The Dow Jones Industrial Average finished almost 300 points higher for the day and the S&P 500 posted its third-largest percentage increase in 2013. Both indices finished the week at all-time highs.
Why did stocks rally so strongly in reaction to a reduced amount of QE? Because the $10 billion per month reduction is modest and because the Fed went out of its way to reassure investors that interest rates will remain exceptionally low. The Fed specifically stated that it will continue with policies designed to "maintain downward pressure on longer-term interest rates." Furthermore it intends to keep the federal funds rate at zero to 0.25 percent "at least as long as the unemployment rate remains above 6.5 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored." Bernanke further stressed during the press conference that "these numbers are thresholds, not triggers." Indeed, the Fed's press release stated that the fed funds rate might remain near zero percent "well past the time that the unemployment rate falls below 6.5 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal."
Stocks rallied simply because the Fed was able to convince investors that despite the reduction in QE, interest rates will remain exceptionally low. Only time will tell if the Fed is correct in its assessment. The Fed can directly control the fed funds rate, but longer-term rates might not behave as the Fed hopes. After all, if the Fed reduces its asset purchases, who will make up the difference? Chances are the federal government will keep issuing debt; but who will buy all the bonds that the Fed will no longer buy? Economics tells us that if demand for a good falls while the supply remains constant, then the price must fall to clear the market. When it comes to bonds, a decline in price translates into higher interest rates. In other words, either the government has to reduce the amount it borrows, or higher interest rates will be required to convince investors to buy the bonds that the Fed will no longer be buying. Will those interest rates go high enough to choke off an economic recovery?
With stocks at record highs, it is clear that QE has been a godsend for equity investors. The S&P 500 has surged more than 160 percent since its 2009 low. Fed-induced low interest rates have punished savers, yet they have handsomely rewarded stockholders. This happened to a large extent because low interest rates gave corporations access to cheap money, which they used to finance share buybacks.
It is less clear, however, if QE has done much good for the economy. The unemployment rate has improved, but that's due more to people dropping out of the workforce than it is to people actually finding jobs. As for the jobs that have been created, they are not particularly good ones. Today, we have a lot more waiters and bartenders than we used to, but we also have a lot fewer of the well-paying jobs that existed before the financial crisis began.
The housing market has also improved and is well off its lows. At least some of the strength, however, is coming from institutional investors buying foreclosed homes. There does not seem to be a lot of demand from the ordinary family who wants to buy a home to reside in because the primary breadwinner got a big raise. Despite signs of improvement in housing, the most recent sales figures for existing homes were disappointing. With 30-year mortgage rates about 100 basis points higher than they were a year ago, further improvements in housing may fail to materialize.
As for GDP, the third estimate for third quarter growth was a surprisingly strong 4.1%. That's great, but it unduly benefited from a rather large change in real private inventories, which added 1.67 percentage points to the overall GDP gain. To put that in perspective, during 2010-2012 the contribution from inventories averaged only 0.5 percentage points. The Federal Reserve's own longer run central tendency projection for real GDP growth is just 2.2 to 2.4 percent.
So based on the overall evidence, I have to conclude that the market is anticipating a much more significant improvement in economic growth than is likely to occur. Furthermore, don't forget about the important structural changes taking place in the economy (e.g., the ability of corporations to get more done with fewer workers). These changes do not bode well for employment and housing. Corporations have been generating profit growth, but not by selling more goods. Those profits are being produced primarily by reducing expenses (including human expenses). The Fed's low-interest rate policies have made safer-investments (such as CDs) extremely unattractive. Those wealthy enough to assume the risks have turned to equities. In addition, few corporations have been willing to make significant investment-related capital expenditures; but thanks to the Fed's policies, they have been happy to use cheap money to finance share repurchases. There can be no doubt that the Fed's policies have boosted stock prices. But now that QE is being reduced and the overall economy remains weak, is it not too risky to bet that stock prices will keep rising?