Excess Fed Fears

Just how much power does this gentleman have to move markets? Source: Getty Images.

For even those quickly surveying financial headlines recently, it would be difficult to avoid the hypothesis that the Fed’s slowing, ceasing or unwinding the pace of bond buying would be bad for stocks. In just the last two weeks, headlines have blamed Fed chatter for daily negativity, with some citing these wiggles as evidence removing or dialing back quantitative easing (QE) is bearish. To put it succinctly, we disagree. In our view, the evidence citing a correlation (and alleging causation) between dipping stocks and chatter about QE’s end is subject to potentially extreme behavioral error.

Those who consume a great deal of financial media (MarketMinder’s writing staff views roughly 120 blogs and websites daily, for example) would likely attest to the fact a Fed official saying this or that about the exit strategy is a near daily occurrence. And it’s not a very recent phenomenon—it’s gone on for most of 2013. Some even attribute foreign equity volatility to the same Fed. Even on up days, it seems many presume this is all a bet on stimulus and not some other factor, like economic or market fundamentals. Yet on down days, the linkage is easy to find. And sometimes, it’s headscratching—like the notion bond prices would rise if markets were pricing in less Fed bond buying. Yet, the opposite would seem to better reflect how markets function.

All this seeking-singular-cause-for-market-outcome logic is territory filled with biases and behavioral errors—not very sound evidence gathering. For example, there have been plenty of unclear Fed statements, or could be interpreted to mean less QE ahead—and stocks rose. It seems to us many folks are busy selecting evidence that agrees with a preconceived hypothesis, while not noticing (ample) contrary evidence.

Now, it’s possible some near-term, sentiment-driven wiggle could ensue around the end of QE (always possible). But to better see why the end of QE isn’t an automatically bearish factor, consider the economic fundamentals of the policy. While QE1 seemed to us fine enough policy—essentially, bolstering bank reserves via bond purchases, thereby adding to banks’ liquidity positions—QE2, Operation Twist, QE3 and what amounts to QE-infinity cannot be similarly justified. Banks are awash in excess reserves—reserves they’re being discouraged to lend by (among several factors) a flatter yield curve. A yield curve flattened by those self-same QE bond purchases! This is the very definition of being at cross purposes.

As it pertains to ending the aforementioned policy, among myriad options are simply ceasing purchases and allowing securities to gradually mature and roll off the Fed’s balance sheet. A very gradual method indeed. That approach likely carries little-to-no surprising shock—especially considering the near-ubiquitous focus on the issue. Should this policy come to pass, the weight of Fed bond buying on long rates would ease—all else being equal, a factor implying higher long rates. That means the yield curve would widen some, boosting loan profitability and, thus, bank eagerness to lend. And increasing bank lending is a vital driver of economic vibrancy.

But arguably more importantly, the weight of this fear on the market would be gradually removed—potentially a factor causing stocks to rise, akin to the post-Fiscal Cliff run.

Now, some might argue that if there’s an extreme move to unwind Fed policy, this could mean trouble for stocks and the economy. And we agree! Yet that’s a near-universal truism. If the Fed takes the wrong step in a big way, it would nearly always negatively impact the economy—that’s not limited to whether policy is generally considered “unconventional.”

Monetary policy is clearly an important input to consider, but the temptation to consider it all-important should be avoided, lest you blind yourself with bias.