“QE Works in Practice, But Not in Theory”
– Ben Bernanke
Last week, in a post about current equity market valuations, we identified the unwinding of QE as a possible threat to today’s bull market. Let us be clear: we don’t think the unwinding of QE (which has already begun, actually) will have any material impact on stock prices. Rather, our concern is more about faulty investor conclusions, which are pretty likely in our opinion, resulting in triggers being pulled on the first QE Unwind-related headline.
A month ago, in the minutes of the FOMC meeting, language appeared that seemed to many a clear indication the Fed would start to let its positions mature without reinvesting proceeds from maturities and pre-payments. The Fed has about $1.5 trillion in maturities due within the next five years, so the great Fed unwind is likely to be gradual. After all the fears about “helicopter money,” rampant inflation and monetary ruin, one can make the claim that QE might have actually worked.
Why the unwind shouldn’t be feared is perhaps best explained by Don Luskin of Trend Macro, who makes the following subtle but excellent point: “QE1 worked because it wasn’t quantitative easing at all. It was a classic prudential intervention, the central bank acting in its role as the lender of last resort – in this case, soaking up agency and mortgage-backed securities that were being dumped world-wide. QE2 and QE3 worked because, well… did they actually work? We don’t think there’s any particularly strong reason to think they did anything at all.”
While stocks sold off immediately following the cessation of QE I and QE II, they also fairly quickly afterward assumed their upward march (as they have pretty consistently for most of the past 100 years. . .) The bond market sold off immediately following the onset of QE I and QE II, and then also proceeded to rally (driven by basic market fundamentals). So, one could indeed claim the impact of QE was. . . not much really, so why should the unwinding of QE III be any different?
If long-term yields actually went UP in periods after QE was initiated, why should we fear that yields will rise dramatically because the Fed is ceasing purchases? A credible case can be made that rates will indeed rise, but it will be because of stronger economic activity, as has been the case throughout history.
Indeed, the biggest issue with QE is the introduction of the unknown – we’ve never had a sustained period where rates were driven by the central banks to zero and below. But, pre-QE, rates always moved in relation to economic activity. Returning to that kind of normal organic behavior should be healthy for markets, just as rates falling in response to economic weakness will also ultimately be healthy.