Lyin’ Eyes And Taper Tremors

Goldman’s clients are asking how the onset of a Fed taper will affect equity markets.

This debate is — how should I put this? — impossible to resolve.

Harley Bassman captured it well in his open letter to the Fed this week. “Clever quants will say that a statistically significant mathematical correlation doesn’t exist between money creation and financial asset prices,” he wrote. “But who are you going to believe, them or your lying eyes?”

The reference, of course, was to the ubiquitous chart of the Fed’s balance sheet overlaid with equity prices. The (slightly) more nuanced figure (below) illustrates the point.

Bassman’s “clever quants” take issue with blanket assertions of a correlation between risk assets and central bank balance sheet expansion because when they hear “correlation” they take it in the most literal sense possible. When you run the numbers, it’s hard to establish causation.

This is a long-running debate, but at the end of the day, you don’t have to be good with numbers to know that when a price insensitive buyer is always in the market, it’s bullish one way or the other. Either there’s a direct connection (e.g., the BoJ buying equity ETFs on days when Japanese stocks fall “too” much) or an indirect one (e.g., the extent to which pushing yields on safe assets to zero and below shoves investors out the risk curve and down the quality ladder until the only places to go are high yield and equities).

From a common sense perspective, trillions upon trillions in liquidity doesn’t just get absorbed with no impact. As Bassman put it, “perhaps on a week-to-week basis asset prices don’t move synchronously with the production of fiat currency, but $20 trillion of money must reside someplace, and with the magic of financial leverage it is quite clear where.” (I’d casually note the irony in Harley’s characterization of Wall Street’s quants as “clever” people. To the layperson, Bassman himself would count as the quintessential example of a “clever quant.” Most Americans can’t do long division.)

Goldman’s David Kostin noted that “from a quantitative perspective, our dividend discount model suggests that the size of the Fed balance sheet could affect the equity market indirectly via the equity risk premium.” The two are negatively correlated. “Intuitively, as monetary policy becomes less accommodative, equities should carry a higher risk premium relative to environments with easy policy,” Kostin wrote Friday evening.

Still, the growth outlook matters more. Or at least according to “clever” math. “While a surprise in the details of tapering could weigh on equity valuations on the margin, changes in the growth outlook will be more critical to the forward path of equity valuations and the ERP remains high versus history,” Goldman said.

The bank also looked at the rate of change, although they used a three-month window. “The second derivative of balance sheet size carries a statistically significant positive signal for equity returns, reflecting the importance of large shifts in monetary policy,” Kostin wrote. Still, the signal from growth expectations was much stronger.

There’s simply too much overlapping causality to settle this discussion. No model is capable of incorporating and controlling for the constantly intersecting dynamics associated with monetary policy, the macro outlook and asset prices, especially when the monetary policy lever in question involves the purchase of those same assets or, at the least, the purchase of assets (e.g., bonds) the yield on which is a critical input in models for valuing the assets under consideration (e.g., stocks).

That’s why it’s always better to take a “lyin’ eyes” approach to this debate. A wide-open liquidity spigot and a price-insensitive marginal buyer is bullish. When the flow slows down, it’ll have an impact.

Even if we can’t precisely quantify the mechanical impact, to suggest there isn’t one is to be hopelessly obtuse. And besides, there’s an unquantifiable psychologically effect too. Goldman’s Kostin alluded to that while discussing factor returns. “The size of the Fed’s balance sheet and the pace of its change have varying implications for performance within the equity market,” he wrote. “For most sectors and factors, neither the magnitude nor the rate of change in Fed balance sheet growth carries a statistically significant impact on returns [which] suggests the signaling effect ahead of changes to the Fed balance sheet size, which is not captured in our model, could be more important for equities than the actual changes themselves.”

Remember, we’ve been down this road before. And I’m not talking about Bernanke in 2013.

In late 2018, incessant headlines about the Fed’s balance sheet, compounded by shrill tweets about QE from the Oval Office, exacerbated market consternation during what ended up being the worst December for US stocks since the Great Depression (the annotated figure, below, could have many more annotations, but in the interest of clarity, I confined myself to a pair).

Although there was a government shutdown in the offing during that stretch, one of the defining features of the December 2018 equity rout was the extent to which market participants scared themselves nearly to death obsessing over balance sheet rundown. There was talk of a recession even though, on most economic indicators, such an outcome was close to being mathematically impossible.

So, when it comes to the taper, the story is always the same. You can’t quantify the mechanical impact on stocks. But if you could, and it was negative, you’d almost surely be understating the case because you can’t predict or measure the psychological burden.

What what is it he said? You have to “Feel the market.”