The End of QE: Some Common Misunderstandings

July 29, 2014

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I have discussed for some time that there are a couple of inherent misunderstandings about the Federal Reserve’s ending of the current large-scale asset purchase program (LSAP), or more affectionately known as Quantitative Easing (QE). The first is “tapering is not tightening” and the second is “interest rates will rise.” Let me explain.

The Federal Reserve has been running extremely “accommodative” monetary policies since the end 2008. The two primary goals of the Federal Reserve have been to artificially suppress interest rates and boost asset prices in “hopes” that an organic economic recovery would take root. As I quoted in “How Effective Has QE Been?”:

“Ben Bernanke, in 2010 following the implementation of QE 2, wrote in an Op-ed for the Washington Post:

“...higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

The suppression of interest rates was hoped to spur borrowing and spending by consumers since nearly 70% of the U.S. economy is driven by consumption. However, with consumers already heavily leveraged, and banks skittish to lend, it failed to occur. However, the biggest beneficiary of the extremely low interest rate environment was corporations which relevered their balance sheets to buy back debt and issue dividends. Today, corporate leverage has hit all new highs as noted by Gerard Minack at Minack Advisors.

Consumer credit is also back on the rise driven primarily by student debt and sub-prime auto loans.

It all ended so well the first time, why not do it again…right?

Unfortunately, for all the ramp up in debt that has occurred, it failed to translate (as hoped) into economic growth.

What the Federal Reserve did accomplish with trillions of dollars of bond purchases was to enable the deficit spending cycle of the Federal Government. Therefore, the reduction, and eventual extinction, of the current QE program combined with an eventual increase in the overnight lending rate will reduce the excess liquidity that is current flooding the markets. In other words, tapering IS tightening of monetary policy.

Tapering Is Tightening

David Kotok at Cumberland Advisors recently addressed this very issue stating:

“The federal deficit was $1 trillion, and the Fed was buying securities at the rate of $85 billion per month, or approximately $1 trillion yearly. Thus, the Fed purchased the entire amount of issuance that the federal government presented to the market. If all things were otherwise neutral, the market impact was zero. There was no influence to change interest rates; hence they could stay very low.

But in the economic recovery phase, the federal deficit commenced shrinking sooner than the Fed commenced tapering. There reached a point at which the Fed was acquiring more than 100% of the net new issuance of US government securities. At that point, the Fed’s buying activity was withdrawing those securities from holders in the US and around the world. Essentially the Fed was bidding up the price and dropping the yield of those Treasury securities, and it was doing so in the long-duration end of the distribution of those securities.

The Fed has taken the duration of its assets from two years prior to the Lehman-AIG crisis all the way out to six years, which is the present estimate. It is hard to visualize the Fed taking that duration out any farther. There are not enough securities left, even if the Fed continues to roll every security reaching maturity into the longest possible available replacement security.

Now the Fed commences the tapering process, incrementally stepping down its purchases of $85 billion per month to lesser amounts. The current rate of purchases is $35 billion a month, or approximately $400 billion at an annualized run rate.

The federal deficit has declined as well…In July, August, September, and October, for the first time, the change in rate between what the Fed absorbs and what the Treasury issues will result in a shift. That shift is a tightening.”

The chart below illustrates what he is talking about.

Since what we are really concerned about is the impact of “tightening” on the stock market, I have included the S&P 500 as well. I have noted that when the previous QE programs ended, so did the run in the markets. Currently, with $35 billion per month still being infused into the financial system, stocks are continuing to push higher. This will likely change over the next couple of months particularly as the correlations between the Fed’s actions and the stock market continues.

Interest Rates Will Rise

It would be one thing if the Federal Reserve only stopped the unprecedented bond buying campaign. However, Janet Yellen is now clearly forecasting that the Federal Reserve is set to start raising the overnight lending rate in the near future.

While ending the current QE program is in effect stopping the “replenishment of the punch bowl,” the raising of interest rates is effectively taking the bowl “off of the table.”

The increase in the overnight lending rate will have a deleterious effect on the overall economy. Initially, it will appear that the markets and the economy are “weathering” the tightening of monetary policy. However, the eventual collision of higher borrowing costs and a weak economy will spark a slowdown or worse. I discussed this previously in “Analyzing The Impact Of Fed Rate Hikes.”

“The next chart shows the impact of rising Fed Funds versus the S&P 500. Once again I notated (vertical blue dashed lines) when rising interest rates coincided with a peak in the financial markets.”

“It should really come as no surprise that rising interest rates, Fed Funds or otherwise, eventually has a negative impact on the financial markets. As interest rates rise, so does the costs of operations, which eventually leads to a decline in corporate profitability. As corporate profitability is reduced by higher borrowing costs, market excesses in price are eventually unwound.

As I wrote in ‘Why Market Bulls Should Hope Rates Don’t Rise,’

‘The problem with most of the forecasts for the end of the bond bubble is the assumption that we are only talking about the isolated case of a shifting of asset classes between stocks and bonds. However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices has very little to do with the average American and their participation in the domestic economy. Interest rates, however, are an entirely different matter.’

The table below shows the history of Federal Reserve rate hikes, from the month of the first increase in the 3-month average of the effective Fed Funds rate to the onset of either a recession, market correction or both.”

The point here is simple. The ending of the current QE program is an effective “tightening” of monetary policy SIMPLY from the reduction of liquidity that has been fueling the rise of asset prices over the last 5 years. However, when that tightening is combined with an increase in interest rates, it becomes an outright “constriction.”

The risk to investors is that with asset prices extremely elevated, particularly in the “junk bond” arena, an increase in interest rates, combined with any slowdown in economic growth, could lead to a rush for the exits. While most are focused on a correction in elevated stock market prices, I think the real risk lies in the “high yield” space where yields are at historic lows and complacency reigns. Anything that upsets the delicate balance of confidence could lead to a panic based selloff that would resemble the 2008 financial crisis.

While I am not predicting such an event to occur, I think it is only prudent to be aware of the risks in order to properly evaluate and adjust portfolio structures accordingly. While the ever “bullish crowd” could be correct that the Federal Reserve has it all under control, 70 years of history, as shown in the table above, says differently.