Fedishizing

Many investors hang on this man’s every word. Photo by Alex Wong/Getty Images.

Taperwatch continued Wednesday, with all eyes on the Fed’s 2 PM monetary policy announcement and potential insight into its plans to wind down quantitative easing (QE). For now, the Fed’s holding steady with the fed funds rate between 0 and 0.25% and asset purchases at $85 billion per month. But in his press conference, Chairman Ben Bernanke said QE bond purchases could begin slowing later this year, and the program could end in 2014.

Stocks were largely flat throughout the morning as investors awaited the Fed’s next move, then sold off after the announcement—not exactly a shocking super-short-term outcome considering media headlines keep blaring that QE’s the only thing driving economic growth and stock markets. That’s a misguided stance, in our view. We’ve long believed QE’s a negative, and its end should be great for stocks.

True easing would make financial activity, well, easier. But the Fed’s brand has done the opposite. By purchasing over $1.3 trillion (and counting) in long-term US Treasurys and agency debt, they’ve pulled down long-term interest rates, which has flattened the yield curve and created a disincentive to lend, lowering the velocity of money and likely keeping growth lower than it otherwise would be. What’s really driving stocks in this environment is underappreciated corporate health—businesses’ ability to invest, grow and profit even with Fed headwinds. Once the Fed slows and eventually stops QE purchases, those headwinds likely fade. The yield curve can steepen, banks can resume at least somewhat normal lending levels, and money can flow more freely through the economy.

This is very bullish, in our view—and even more so because most folks don’t see it that way. They see an economy that will wither and die without Fed support. If, as we expect, the economy does just fine without QE, that’s a huge positive surprise for many investors, and positive surprises tend to move markets up. That’s likely especially true in this case, given just how wacky QE sentiment is. QE enthusiasm rests on economic weakness—basically, investors cheer weak economic and unemployment data, believing weak data mean more easy money.

As a result, good economic data are seen as bad. In fact, one big source of Fed-related jitters Wednesday was the Fed’s improved economic assessment. The FOMC said labor markets have shown “further” improvement—better than the “some” improvement of recent months—and policymakers now see “diminished” downside economic and labor market risks. Great news! In a rational world, that is. In this twisted QE-obsessed world, economic improvement is bad news—a better outlook means quicker tapering. This backward view is likely baked into current stock prices. Once asset purchases stop, investors can probably stop seeing the world through QE-tinted lenses and instead take a more rational look at economic news—that’s likely an additional tailwind for markets.

Of course, this all rests on the Fed winding down QE in a somewhat sensible way—a big IF, considering how much they’ve missed the target thus far. Adding a wrinkle is Bernanke’s potential departure once his term expires next January 31—in a weekend interview, President Obama suggested Gentle Ben may not stay on, though Bernanke himself kept mum when asked during his presser. In our view, the potential changing of the guard bears watching, but likely isn’t a near-term gamechanger. The FOMC is just that—a committee. They vote by consensus, and one new face likely doesn’t change that consensus overnight. Most likely, policy in the near and medium term largely follows whichever course Bernanke and his deputies chart over the weeks and months ahead. That said, some volatility as investors chew over potential replacements wouldn’t surprise.

But over the medium to longer term, what matters for stocks is whether the Fed winds down QE, allowing the yield curve to steepen, without making huge changes to its balance sheet—an approach Bernanke’s already telegraphed. So keep an eye on things, but don’t dread the Fed—QE’s end likely gives stocks some unexpected sizzle.