Sept-Taper Caper

Traders watched markets rally after the Fed’s announcement Wednesday. Source: Spencer Platt / Getty Images.

The great taper caper continued with a somewhat surprising twist Wednesday when the Federal Open Market Committee (FOMC) announced they wouldn’t slow the pace of $85 billion-per-month quantitative easing (QE) bond purchases. Though the FOMC noted economic and labor market improvement since QE-infinity began last year, they want further evidence the improvement is sustainable before tapering starts. When the white smoke rose, trumpets blared and no taper was announced, stocks surged and 10-year Treasury yields fell about 17 basis points—a sentiment-driven rally, in our view. However, this doesn’t change our views on QE—tapering, and eventually ending the program, would be bullish.

Many assume the Fed’s so-called “funny money” is one of the main reasons for this expansion’s growth and bull market—and fear removing the easy money punchbowl will send stocks reeling. But this notion operates on the thesis QE massively added liquidity to markets by increasing the money supply—that isn’t the case. The Fed’s actions have greatly increased M0—the monetary base—but the money hasn’t reached the real economy. It’s largely sitting as excess reserves.

The money supply growth we have seen is also not especially big by historical standards. Exhibit 1 shows M2 money supply growth 222 weeks (roughly the age of the present expansion) into the current and preceding three economic expansions, indexed to 100 at the recession trough as identified by the National Bureau of Economic Research (NBER).

Exhibit 1: Comparative M2 Growth

Source: Federal Reserve, National Bureau of Economic Research (NBER). Recession troughs are official dates identified by NBER. 222 weeks of expansion used to match this expansion’s age to date.

The single biggest surge to this point in an expansion occurred in the 1982-1990 expansion. Today’s M2 growth is more or less in line with the 2001-2007 expansion. You’ll note QE was not used in any of the preceding three expansions. So a major reason to not fear the Fed yanking away the punch bowl is there is no actual punch in the bowl—money supply hasn’t grown.

Another way to see this is through comparing loan growth to prior expansions. Bank lending is a major transmission mechanism converting increases in the monetary base—the factor the Fed directly increases via QE—into M2 money supply. But relative to previous expansions, loan growth is anemic—and that’s coming off an ultra-low base following the financial panic-born credit freeze (Exhibit 2).

Exhibit 2: Loan Growth in Last4 Expansions

Source: Federal Reserve, National Bureau of Economic Research (NBER). Recession troughs are official dates identified by NBER. 222 weeks of expansion used to match this expansion’s age to date.

Before delving deeper, note the abrupt increase beginning around week 43 for the current expansion. This is due to accounting rule changes known as SFAS 166 and 167, which essentially required banks to move off-balance sheet loans onto their balance sheets for reporting. But even including this change, loan growth during the three previous expansions outpaced current loan growth by a significant margin.

In our view, this is largely due to QE’s downward pressure on long-term interest rates, flattening the spread between short- and long-term rates, making lending less profitable for banks. If and when a taper takes place, we’d expect loan growth to increase as banks will have more incentive to lend, given the prospects of higher profit margins. As banks increase lending, more money is funneled into the economy, where it’s used in various growth-enhancing ways. QE stands in the way of that.

If QE isn’t propping up the US economy, what is? The private sector’s sheer underlying strength. Manufacturing and services PMI surveys are advancing. Consumer spending is up and wholesale inventories are low, suggesting firms can’t keep up with rising demand—necessitating restocking. Even more important, in our view, these fundamentals (and many more) are largely underappreciated, allowing the market to grow on the gap between reality and expectations. QE, among other factors, has largely fooled some into thinking fundamentals are worse than they are—bullish for those who see through the mist.

As legendary investor Benjamin Graham once said, “In the short run, markets behave like voting machines, but in the long term, they act like weighing machines”—short-term movements can be sentiment-based, but over time, fundamentals rule. A taper may not have come Wednesday—to the cheers of many—but that doesn’t mean it won’t soon. And we expect fundamentals will be better off past the taper.