Wall Street is fixated on how long the surge in earnings brought forth by a growing economy and last year’s tax cuts will last, but it is also fretting about how many times the Federal Reserve will raise interest rates this year. Some Fed-watchers are predicting four rate hikes, and others only two. Even the voting members of the Fed are unusually varied in their opinions as to what should be done on the interest rate front. While all this debate feeds the news headlines, and provides gainful employment for financial pundits, the real story is hidden from public view. Far more important than the 0.25% baby steps the Fed taking in raising interest rates is the unwinding of the extraordinary monetary policy of the past ten years. Rather than adding to the pool of liquidity, the Fed is now draining the pool, and this could have a profound effect on asset prices going forward.
From 2008 to 2014, the policy known as “quantitative easing (QE)” was an attempt to reliquify a banking system brought to a crawl by the collapse of the credit bubble of the mid-2000s. This involved the Fed buying high-quality bonds from banks and giving them cash, in essence printing money. And this was no small print job, as the Fed purchased over $3.5 trillion of securities over the period. Modern central banks are no longer tied to the gold standard, and thus not constrained as to the amount of money they can create. Therefore, they can essentially print money out of thin air. The Fed (and other global central banks) used this to dramatic effect by quadrupling the size of their balance sheet. This in turn was a gusher of a windfall for Wall Street and banks, which channeled these funds into lending, mergers and acquisitions, and outright purchases of securities and real estate. The result was the bull market in asset prices that we enjoy today.
In 2017, the Fed determined that it had accomplished its goals of getting businesses and households back on a normal track of investment and consumption, and announced its plan for the unwinding of QE. The process, now called “quantitative tightening (QT),” involves a reduction in the size of the balance sheet. The mechanics of how this is to be accomplished were summarized in the Market Outlook-August 2017. The point investors should realize is that the Fed is carrying forward with its QT plan, despite the change in Fed chairmen and the many policy changes brought forth by the Trump White House. They are committed to bringing monetary policy back to the normal state that existed before the 2008 financial crisis.
As the chart below shows, the Fed has continued to reduce its holdings of bonds since late 2017, and is on track to let the balance sheet shrink by $30 billion a month in the third quarter of 2018. Because QT is still in its early days, the shrinkage of the Fed’s balance sheet is almost imperceptible on the 2007-18 time frame (upper chart). But zooming in shows the consistency with which they are living up to their QT promise, and shows no sign of hesitation (lower chart). Investors can track the progress of QT by going to the following link: (https://fred.stlouisfed.org/series/WSHOL).
The draining of this pool of liquidity is not just an academic exercise of interest to monetary egg heads, but has important implications for everyday investors. Contrary to the widely held assumptions of modern portfolio theory, stock prices depend on more than just earnings for growth. They depend on money also. Market analyst Tom McClellan perceptively wrote that only two things matter for stock prices: How much money is out there, and how badly does it want to be invested? Over the last nine years the answer to the first question was “a lot,” and the answer to the second was “pretty badly.” Now, the answer to the first question is changing under QT, as the quantity of available cash is slowly being drained from the system.
We are already seeing some effects of QT. The recent corporate tax cuts have caused a major upward revision in earnings estimates for 2018. Indeed, companies have reported much better than expected earnings for the year so far, yet the major indices have only risen a few percentage points through the end of May. If earnings were all that mattered, we would have seen a much greater rise in stock prices. Perhaps these higher earnings were factored in already, and so today’s results are no longer a positive surprise. We believe, however, that QT is starting to take its toll on the ability of stock prices to advance. The moderation of liquidity is affecting the demand for stocks, and thus making progress much more sluggish.
The other side of the coin is the rise in interest rates. QT will naturally cause interest rates to rise, as higher rates are needed to entice investors to buy bonds. Unlike QE, which put cash in the hands of banks, QT removes cash from the banks as they are increasingly being called on to buy bonds from the Fed and also fund bond maturities. As bond yields rise off their near-zero levels of the past few years, they become more attractive for conservative investors. Safety-conscious investors who have traditionally bought bonds, CDs, and money market funds have paid the highest price under QE, as they saw their investment incomes plunge when interest rates were forced to the floor. Of course, many of them sought returns in stocks, which was part of the Fed’s intent. Now, at least at the margin, those investors are snapping up bonds which, even at today’s modest rates, yield many times what they did two years ago.
QE was a radical monetary policy that can trace its beginnings back to Alan Greenspan and the 1987 market crash. Every financial crisis since then has been met with a flood of liquidity and ever lower interest rates. The idea, of course, was to get consumers to borrow more (increasing demand), or provide the ability to refinance unsupportable debt to more affordable levels. This has prompted some analysts to ask whether the business cycle has been replaced by a credit cycle.
Economists have traditionally viewed the business cycle as being driven by ebbs and flows in demand, inventory overhangs, and inflation. The Fed has played a lagging role in this cycle, responding to higher inflation and rising wages by raising interest rates, making borrowing more expensive. This dampened demand, lowering production and raising unemployment, and interest rates would drop and start the cycle all over again.
What has evolved over the last 20 years, and especially the last decade, is that the central bank is leading the cycle rather than responding to it. By cutting rates to low extremes, the Fed has encouraged us to borrow with nearly “free” money.
This is not new. The Greenspan Fed held rates artificially low in the late 1990s due to the 1998 Asian currency devaluation and concerns over Y2k computer failures. But they were slow to withdraw the extra liquidity. Bernanke also followed this pattern, being overly generous to borrowers in the mid-2000s which led to the mortgage bubble and subsequent collapse.
But over time, the marginal ability of debt to stimulate growth diminishes. The recovery from 2008 is the prime example, where the stimulus of $3.5 trillion extra dollars was only able to generate middling GDP growth of about 2%. Part of the problem is that debt-fueled growth pulls forward future spending, leaving future demand less than it would have been.
According to this view, if debt drives so much of GDP growth, then its price (i.e. interest rates) is the main variable in determining where we are in the credit cycle. The Fed controls those costs (at least short-term rates), and so is the major cyclical influence. If the Fed-driven credit cycle has now supplanted the traditional business cycle, then recessions are more likely to be caused by high levels of debt than by a falloff in consumer or business demand. In other words, if interest rates rise, it makes servicing debt that much harder. Struggling, debt-laden firms (or municipalities) may be forced to cut costs by laying off workers and generally retrenching in order to avoid default. We saw an example of this in 2007-08, as debt-laden households began to default on mortgages (especially variable rate mortgages), which created the negative feedback loop that led to the demise of Fannie Mae, Washington Mutual, and infamously, Lehman Brothers.
This alternative view is far from being accepted on Wall Street, and indeed, stocks have ignored any bearish implications of high levels of borrowing. Margin debt hovers just slightly below its January high, and junk bond issuance continues with gay abandon. Moreover, lending standards are starting to resemble the worst practices of the mid-2000s as “covenant lite” and PIK (payment in kind) bonds are proliferating. But strong earnings have served to counterbalance the increasing level of debt at both the corporate and household level. As long as revenues and cash flows remain strong, debt levels can remain tomorrow’s worry. Moreover, if investor confidence remains high, stocks will probably remain the investment of choice for the near term. This is reinforced by positive trends in the daily and weekly advance decline lines, which have moved to new highs in recent weeks. In addition, the Bullish %s for the S&P 100, NASDAQ 100, and Russell 2000 (below) indexes have changed to buy signals, indicating that demand for stocks is returning after the February-April swoon. So while the Fed has begun to drain the pool, it appears equity investors are still enjoying the water.