Somehow, I feel it’s necessary to reiterate the general thrust of “Too Far Gone,” an admittedly lengthy, multilayered article that found me knocking over a digital inkwell in the course of covering quite a bit of ground in characteristically breathless fashion.
On Saturday afternoon, a few hours after that linked article was published, Bloomberg ran a piece called “Taper No Grounds for Tantrum to Stock Bulls Wielding $28 Billion.” The $28 billion figure was the total plowed into equity ETFs over the past week, but the article turns on a model from UBS, whose Keith Parker found that (and I’m quoting the article here, not Parker himself) “every $650 billion change in annualized net Fed purchases is worth a roughly 1% move for the S&P 500, all else equal.”
So, theoretically, the Fed could fully taper its monthly buying and the mechanical headwind to the S&P would be around 3%, an insignificant figure that pales in comparison to the expected boon from profit growth.
The first thing to note is that every major bank has tried to model this at one point or another for obvious reasons (figure below). There are tons of these models dating back years.
The second thing to note is that, as Bloomberg’s Lu Wang euphemistically put it, “the precision” of forecasts which purport to quantify the likely impact on equities from central bank tapering “is famously squishy.”
It’s not so much that the models are “bad,” per se, it’s just that there are too many variables to realistically incorporate, not least of which is concurrent action (inaction) by foreign central banks, whose own monetary policy decisions (indecisions) have spillover effects for USD assets, including stocks, both directly and because foreign demand for US fixed income affects yields, which in turn has implications for equity valuations. Additionally, tapering is tantamount to tightening, and that isn’t lost on the dollar and real yields. If they rise, that can undercut risk assets.
And that’s to say nothing of the idea that even if there were no mechanical impact at all, correlation can end up being causation if people believe it. If I tweet out a lollipop emoji once every three weeks and by sheer happenstance, stocks fall every time I do, it won’t be too long before investors start selling stocks because I tweeted a lollipop. JPMorgan’s Marko Kolanovic alluded to this in January of 2019. “Whatever the real mechanical impact [of balance sheet rundown] is, likely the impact on market sentiment is much larger,” he said, citing intraday movements that coincided with balance sheet mentions.
Simply put: It’s impossible to model this relationship. This is the quintessential example of that old adage about things that “look and quack like ducks.” You don’t need a model to know that trillions upon trillions in liquidity is prone to inflating financial assets and that when you reduce the flow, the same assets are likely to fall or, at the least, de-rate. As noted in the preceding paragraph, even if a complex model would help, the sheer number of relevant variables involved and the necessity of incorporating various domino effects, means you’d need to enlist Einstein and Nostradamus to create something that had any hope of being sufficiently comprehensive and predictive.
The gist of “Too Far Gone” (the article linked here at the outset), was that real normalization (i.e., policy that could plausibly be described as neutral) isn’t possible without dramatic consequences across assets because we simply don’t know how to price something like a 10-year Italian bond anymore. Ask yourself what the market-determined clearing price for periphery European debt would be in an environment where the ECB backstop wasn’t there and US real yields were, say, positive 1%. Nobody knows the answer to that. And there are countless similar questions one could ask.
You can always make the simplistic argument that as long as earnings growth is robust, stocks will be fine. But at every turn, serious investors are compelled to consider the price of money, the risk-free rate and liquidity when assessing valuations, the relative attractiveness of equities and market conditions. Money has been free, risk-free rates have been zero and liquidity has been (more than) abundant for so long that I doubt it’s possible to revert to a policy conjuncture that’s materially different without everything falling apart.
It’s not as if we haven’t seen this movie before. And quite recently at that. Jerome Powell tried this in 2018 and it dead-ended in a near catastrophe (figure below).
So, if you skipped “Too Far Gone” (or read it and then read the linked Bloomberg piece mentioned above), allow me to gently suggest that no, the Fed won’t be able to taper asset purchases, let alone hike rates without causing serious problems for risk assets.
As I put it Saturday morning, they may be able to pull off a truncated version of the last taper, and mount a similarly abbreviated rendition of the last ill-fated attempt to embark on a hiking cycle, but ultimately, there’s no way out of this. Although the fireworks in the curve late last week were obviously exacerbated by stop-outs, short covering and the sudden abandonment of “sure thing” steepeners, it wouldn’t be surprising to see the bond market try to force the Fed to abandon even the pretense of tightening by now leaning into flatteners and creating a bad growth optic.
When it comes to rates, look again at the figure (above). 10-year reals were well in excess of 1% when the last tightening cycle finally “broke” the stock market. Right now, they’re at negative 75bps. Remember, that’s basically the inflation-adjusted opportunity cost of doing something other than investing in a risk-free asset. When that cost hit 1.10% (or thereabouts) in October/November of 2018, stocks collapsed. Currently, that cost is punitive — you’re punished for not taking risk. Allowing it to get anywhere near positive territory with equity valuations at dot-com levels is an extraordinarily perilous proposition. Which is why the Fed probably won’t allow it unless it’s absolutely clear that everyone would interpret it as an unambiguously positive signal about the health of the economy.
“An ‘easy Fed’ has been an ‘easy trade’,” BofA’s Michael Hartnett said late last week, before warning that in the second half, “good news” will equal “tighter liquidity” which “equals bad news.”
While balance sheet rundown is something different from tentatively tapering aggressive monthly purchases, and although Kolanovic remains constructive on risk assets (as far as I know anyway), I think it’s worth recycling another quote from the same 2019 note mentioned above. “While there may be little or no mechanical impact on equity prices, most macro traders are not ‘fighting the Fed’,” Marko said. “When liquidity is added they are buying assets, and when liquidity is removed they are selling assets.”