the start of “tapering”

Yesterday afternoon, the Fed said the recovery was far enough along that it can start “tapering” before the end of 2021. The stock market dropped sharply on this news before recovering before yesterday’s close (btw, typical market behavior on almost any Fed news).

What does this mean?

The primary money policy tool the Fed uses is the Fed Funds rate, which it sets, and which is the rate banks use to lend and borrow money overnight. This is the shortest of short-term rates. In most circumstances, changes in the Fed Funds rate ripple quickly through longer maturities–like the Treasury market and the rates on loans banks charge their corporate customers. But during the 2008-09 financial crisis, longer-term rates stayed stubbornly unmoved by anything the Fed did with the Fed Funds rate. So the Fed resorted to “unconventional” measures. It started to buy lots of longer-dated Treasuries for itself. The relative scarcity this creates pushes Treasury yields down, because other buyers, like banks and investment companies, have to offer better terms (i.e., accept lower rates) to make a purchase than they would if they were the only ones bidding for the securities.

Yesterday, the Fed said it would begin to “taper” (reduce) the mammoth level of Treasury purchases it has been making regularly during the pandemic. When Ben Bernanke said something similar in May 2013, his statement provoked a “Taper Tantrum” of higher rates in the bond market. This time, not so much, at least so far. My guess is that’s because this is the second time we’re seeing this situation and have some past experience to rely on.

What does this mean?

For some time I think we’ve been in an inbetween conceptual space. We knew in a vague way that, at some point, the period of near-zero interest rates would be over. But because we had no firm evidence about when, the markets had no reason to react in more than in a vague iffy way.

Now the situation has changed. We don’t have the certainty that we will when tapering actually begins (December?). But the market background of near-infinite monetary accommodation (and near-zero rates), which allows firms with even so-so earnings prospects to trade well, is fading away. In its place, we’re moving into one of rising interest rates. Yes, by historical standards they’ll remain low: my idea is that the 10-year Treasury will ultimately settle in at about 3%; the consensus, as I see it, is 2.5%. But relatively strong earnings growth, and especially near-term growth, will be the principal (only?) defense against the market PE contraction that higher rates will induce.

A second, less adequate, I think, defense is what I think of as “you can’t fall off the floor” stocks. Ones that may have limited prospects but which are already trading as if they’re road kill. Macy’s (M), up by 22% today, is indicative of the type. This may be another way of saying that traditional value stocks will enjoy one of their increasingly rare days in the sun.

So we’re entering a new phase of the stock market, where valuation and conviction in the solidity of earnings growth in 2022-23 will be increasingly important considerations. Pure story stocks will do less well. PEs will count for more, although bonds at 3% imply stocks will still be selling at 33x earnings.

One complicating factor: the false Trump COVID-is-a-hoax narrative, still professed by acolytes Abbott, DeSantis et al, which continues to prolong the pandemic–and retard economic recovery in areas like travel, entertainment and dining…. We can already see this reflected in the collapse of the related stocks over the past month or two. It’s unclear, to me anyway, given the obstinacy of pandemic denial, whether weakness will be confined to the directly affected stocks or will spread wider.

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