After a rather ho-hum stretch of folks not worrying about anything, it seems some investors are slightly concerned that central bankers the world round are considering removing their "support" of the global economy.
In particular, folks are murmuring whether institutions from the European Central Bank to the Bank of England might soon follow in the footsteps of the U.S. Federal Reserve. However, the American experience may be instructive for investors and show why "accommodative" monetary policy isn't all that it's cracked up to be.
Let's go back to 2010, when the bull market was a mere toddler and the Fed was just amplifying its quantitative easing (QE) program. The big fear then? Hyperinflation. In the subsequent seven years, the Fed remained in the spotlight as fears morphed from hyperinflation and growing bubbles to popping bubbles and monetary tightening.
Even now, you can virtually bank on a Fed-related fear cropping up in the financial press almost daily. This obsession over the Fed and its actions has been a constant source of false fears for more than eight years, but in our view, the time to be concerned is when folks stop paying attention.
Let's start at the beginning. In an effort to boost liquidity to combat the recession, the Fed launched its first round of QE in January 2009, two months before this bull market's birth. Through QE, the Fed ostensibly sought to stimulate the economy by buying long-term debt -- boosting bond prices and thus lowering long-term yields, ideally spurring borrowing.
One problem with this: Lower long rates combined with short rates fixed near zero meant a flatter yield curve, which discouraged lending--correspondingly, loan growth was anemic during QE. It's hard for businesses to grow if they don't have the capital as fuel.
Regardless, American QE was expanded two (and arguably three) times thereafter, before concluding at 2014's end. Throughout that stretch, the Fed took center stage, subjecting itself to speculation and criticism. In 2010, some critics argued QE1, QE2 and zero interest rates would lead to runaway inflation, jarring markets. Didn't happen. Those arguments later transformed into charges of QE-inflated bubbles (ranging from Emerging Markets to the U.S. housing market) that would pop once the Fed tapered bond purchases. That didn't happen, either.
Even so, folks didn't stop worrying. They simply shifted to the next Fed-related action: rate hikes and their potential negative fallout on everything from bonds to the dollar -- which would then knock stocks.
Well, the Fed has hiked four times since December 2015, and everything still appears to be standing, rendering fears again misplaced. Now there is chatter about how the Fed will wind down its balance sheet.I
Yet the Fed could simply do nothing -- i.e., stop reinvesting the proceeds as the bonds mature--and thus gradually reduce its balance sheet (and they've signaled as much recently). For all Fed fears' hype, they have yet to deliver. We don't think they're just late bloomers.
Exhibit 1: A Flawed QE Chart Through 2015
Source: Federal Reserve Bank of St. Louis and FactSet, as of 6/29/2017. US Treasury Securities Held by the Federal Reserve and S&P 500 Price Index, weekly (ending Wednesday), 12/31/2008 - 12/30/2015.
We explained back then that this chart was very misleading for a number of reasons, specifically because it omitted dataii and mismatched the Y-axes.
Now, with more time, it's clear even the tortured chart above has broken down. (Exhibit 2) Moreover, a more accurate way to look at these data suggest fears here were never freaky. (Exhibit 3)
Exhibit 2: The Flawed Chart Fell Apart
Source: Federal Reserve Bank of St. Louis and FactSet, as of 6/29/2017. U.S. Treasury Securities Held by the Federal Reserve and S&P 500 Price Index, weekly (ending Wednesday), 12/31/2008 - 6/28/2017.
Exhibit 3: The Real Correlation Between Fed Activity and Stocks (None)
Source: Federal Reserve Bank of St. Louis, as of 6/29/2017. All Federal Reserve Banks, Total Assets; Treasury Securities and Mortgage-Backed Securities (MBS); Treasury Securities of Maturities Exceeding 1 Year plus MBS; and S&P 500 Return Index, weekly (ending Wednesday), 1/14/2009 - 6/28/2017. Indexed to 100 on 1/2/2008.
We know there is a lot going on with Exhibit 3 (which shows growth rates, not absolute levels, hence why total Fed assets are below the other two lines, which represent narrower slices of the balance sheet), but the broader point is this: No matter how you slice it, the growth rate in the Fed's various actions dwarfs the growth rate of stocks. That isn't to pooh-pooh U.S. stocks' 200%+ rise over the past eight years. However, the Fed's activities have been overwhelming in comparison, whether you isolate for QE or consider the totality of all the assets the Fed acquired. For all those clamoring about how Fed asset buying was the only thing propping up stocks, we fail to see the connection.
Heck, even at a pure theoretical level, there are issues. Many claim QE lowered bond yields, driving investors to seek yield in stocks. But why would this be true? If bond holders presume more QE is coming -- and lower yields -- they'll correspondingly expect higher bond prices. That ... is ... how bonds work. Fund flows better support this notion, as bond funds saw much bigger inflows than stock funds -- which often saw net outflows -- during QE.
There were also concerns that the first Fed rate hike would wreak havoc on financial markets, despite the wealth of historical data showing rate hikes aren't automatically bad for stocks. The microfocus on hikes persists, as many folks debate whether the next hike will be the one to squash stocks. However, this is misplaced.
A hike, or even several, from historically low levels won't cause the real problem: an inverted yield curve. While hikes may flatten the yield curve a bit, the Fed still has room before inverting is a real threat. Despite some narrowing recently, the yield spread is still plenty wide.
Exhibit 4: The Yield Spread
Source: St. Louis Federal Reserve, as of 6/29/2017. 10-Year Treasury Constant Maturity Minus Federal Funds Rate, from 6/29/2012 - 6/28/2017.
None of this is to say you should outright ignore the Fed, especially since there is plenty of history of them screwing up. But in our view, when folks no longer widely fret the Fed -- and perhaps even no longer pay it any heed -- is the time to be worried.
Right now, every single word a Fed person says is dissected and treated like prophecy.iii But eventually this fear morph could stop. After enough hikes pass without catastrophe -- we're three deep already! -- people will get more desensitized. Whenever the Fed decides to allow its bonds to start maturing -- again, without disaster -- more folks who long feared Fed action will see the media as the boy who cried wolf.
This is when it's time to be concerned: When everybody stops paying attention to monetary policy, the Fed will continue about and perhaps make a mistake nobody sees at the time (e.g., invert the yield curve). They've done this before. We don't believe they are close now, and they won't necessarily do it any time soon, but don't forget, after all those false cries, the wolf eventually came.
i At this point, you probably have a strong inkling of how we feel about this concern, too.
ii Folks excluded mortgage-backed securities, which the Fed's QE program also targeted. Also, many charts cited S&P 500 Price returns, ignoring dividends. Yet dividends are a big part of total return -- so using S&P 500 Total Return makes more sense, in our view.
iii An exaggeration, but just barely.
Fisher Investments is an independent, fee-only investment adviser serving investors globally. To learn more about Fisher Investments, please visit www.fisherinvestments.com.
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