No reason to fear tapering

The US labor market report was stronger than the consensus of Wall Street economists predicted or whisper numbers among traders indicated. Before the release of the report, markets feared a stronger report would signal the Fed would taper at the next meeting. However, financial and commodity markets only briefly traded lower but after a few minutes reversed direction and traded higher. Thus, many markets traded like it was selling the rumors and buying the facts. Nevertheless, neither the S&P 500 Index nor most precious metals managed to end the week higher than the Friday before.

In a market report published by ThomsonReuters, one trader was quoted that US stock markets trade higher because the market now knows that the economy would be able to absorb the negative impact of tapering by the Fed. This statement just underlines that financial markets are not always information efficient as academic theory postulates. For more than six months now, the Fed emphasized that the decision to reduce the volume of monthly bond purchases would be data dependent. This implies, that the FOMC would only decide to taper if the majority of the voting members were convinced the economy were on a sustainable growth pace, which implies that tapering would not hurt the economy.

Some analysts and asset managers argued that the rally in stock and commodity markets were driven only by the liquidity provided by the Fed. If this argument were correct, then stock markets were in a bubble. Precious and industrial metals as well as the markets for agricultural commodities corrected this year. Thus, the liquidity of the bond purchases did not flow into most commodities any longer. For gold and silver, we pointed out in this blog that the shift in Japan’s economic policy to overcome the deflation was the crucial factor for the correction. For industrial metals it was high stockpiles and fears about Chinese GDP growth, which dominated the market developments. Thus, for the commodity markets, the argument that only the Fed liquidity injection by QE3 drove prices higher was obviously wrong. But is it also wrong for US stock markets?

We developed some macroeconomic indicators for various stock market indices, which are all based on the macroeconomic portfolio theory of Prof. James Tobin, which he created to study the economic impacts of fiscal and monetary policy measures. This indicator does not include any monetary aggregate like money supply or the size of a central bank’s balance sheet. The indicator is based on monthly macroeconomic variables which are highly correlated with GDP growth. Also short- and long-term interest rates are included.

As the chart shows, the macro-indicator only had a brief decline in the second quarter this year. The shaded area indicate when a moving average of the indicator is increasing and thus provides a set-up for a buy signal. It is worth to note, that the macro-indicator rose in the second half despite the yield on 10yr US Treasury notes provided a negative contribution on balance. The major moves higher of the S&P 500 index took place when also the macro-indicator signaled a bullish environment for the stock market. Thus, we have to come to the conclusion, that QE3 was helpful for the stock market rally, but the rise of equity prices was not driven solely by the Fed buying bonds but also by favorable macroeconomic fundamentals.

Furthermore, we have to conclude that the fear in some financial markets about the impact of tapering are overdone. They were only justified, if tapering would lead to a deterioration of economic fundamentals. However, the FOMC also emphasized that the volume of bond purchases could be increased again if the economic development worsens after the committee decided to taper. Therefore, the downside risk for the US economy appears to be rather limited as the FOMC remains ready to act when needed.

After the release of the US labor market report, the question is now, whether this report would now tip the balance among the FOMC voting members already at the December meeting. The decline of the unemployment rate to 7.0%, which was accompanied by people returning back to the workforce is certainly a strong argument. Also the number of job creation is more robust than economists predicted. However, in the Beige Book, which serves as a basis for the FOMC decisions, the regional Reserve Banks preparing the report, paint a picture of modest economic development. Thus, from our point of view, a tapering decision at the next meeting appears still not as the most likely scenario. However, the probability for reducing the volume of monthly bond purchases in Q1 next year has clearly risen. 

Nevertheless, there is no reason to fear tapering. The rise of the US stock market was well supported by economic fundamentals. The Fed will keep the short-term interest rate, the Fed Funds target rate unchanged well into 2015. The yield on 10yr US Treasuries has risen further to 2.88%. Thus, the yield curve is rather steep and attractive for carry trades, which should limit the upside risk in the US Treasury market. But tapering might be positive for the US dollar, which might appreciate against major currencies as the ECB and the Bank of Japan will continue to stick to a very expansionary monetary policy. For the metals markets, the risk of a firmer US dollar is the major risk of tapering by the Fed. But as the FOMC heralded this move for more than six months, it should now be priced in.