Why the Fed’s Taper Hasn’t Hurt the Stock Market… Yet

Today (Wednesday, July 30) at 2 p.m. Eastern time, the Fed will issue a statement on monetary policy. I don’t expect it to contain any surprises. The Fed will continue to taper by reducing its quantitative easing (QE) purchases by another $10 billion/month, bringing total purchases to just $25 billion per month.

Further, I think the Fed will stick to its plan to end QE purchases altogether by October:

The Fed simply has no reason to deviate from its tapering plan. Normally, monetary tightening produces undesirable effects. But none of those effects has shown up yet. Stocks continue to rise. Long-term interest rates remain ultra-low. The unemployment rate is improving. And inflation—at least as the government reports it—is rising only modestly.

Naturally, the question is: how has the Fed managed to taper without roiling markets?

The answer: the Fed has printed so much money in the past few years that it can afford to take a breather. Since 2013, the Fed has been growing its balance sheet (by buying Treasuries and mortgage-backed securities) faster than the government debt has grown.

As you can see in this chart, the growth of US government debt (gold line) and total Fed assets (gray line) both exploded as part of programs to stimulate the economy after the credit crisis of 2008. The basic mechanics were that the US government borrowed money by selling Treasuries, and the Fed bought a large portion of those Treasuries with freshly printed money.

But look closely and you can see that since 2013, the Fed’s balance sheet has grown faster than government borrowing:

In essence, the Fed printed enough money to meet the demand for credit and then some—which has afforded it some leeway to taper for a little while.

All that new money creates side effects, of course. The Fed’s liquidity kept interest rates low and drove asset prices, including the stock market, higher. As you can see here, it’s crystal clear that the Fed has driven the stock market higher since the financial crisis:

Now that it’s slightly ahead of the game, the Fed can ease its foot off the gas without causing the immediate reversal of those effects.

So what’s next? The government is still borrowing hundreds of billions of dollars per year, so the Fed can’t nix QE forever. Not to mention that the accumulated “surplus” of printed money will only last a couple of months. Sooner or later (probably sooner), the stock market will start to feel the pain of this monetary tightening.

By zooming in to look at the monthly changes of the Fed balance sheet vs. the stock market, we can see that the lack of QE will be a major headwind for the stock market:

My guess is that if the stock market drops 20-30% by 2015, the Fed will be back with more QE.

Notice what we’re not talking about here: an exit strategy. The Fed is merely reducing its asset purchases; it’s not even considering selling the $3.5+ trillion in assets that it has accumulated since the financial crisis. That’s no surprise; there's zero political will for anything that might slow the economy, cause stocks to fall, or cause rates to spike—especially in an election year.

I don’t see any “Exit Ahead” for the Fed.

What I’m More Worried About…

I find it amazing that most economists still don’t recognize the importance of political conflict on economies. Economists love anything expressed in numbers: they’ll analyze Fed minutes, GDP, interest rates, and unemployment to death. But because political conflicts aren’t quantifiable, economists largely ignore the crucial impact of wars.

I admit that we have no way of predicting wars, so the analytical tools are inadequate. But the simple fact is that history is defined more by war more than by economic theory. For that reason, I’m much more worried about the wars brewing in Ukraine, Iraq, Gaza, and Africa than Fed actions.

Just a quick look at the redrawn borders of Iraq shows how dire the situation has already become:

These conflicts look like they’re only going to get worse. In the case of Iraq, it’s likely that the world will lose access to Iraq’s oil supply for at least a while.

I analyzed the implications of losing Iraq’s oil in If Iraq Implodes, Stocks Will Plummet. In a nutshell, energy prices would spike… and energy price spikes have historically been very bad for the US stock market. Of course, there’s much more to the story; you can get my full analysis in the latest edition of The Casey Report. If you’re not yet a subscriber, I encourage you to take us up on our generous 90-day risk-free trial by clicking here.

Overall, my conclusion is that while the Fed’s actions are important, world geopolitics are more important. I think economists who fret over the wording of the most recent FOMC release are missing the big picture. Geopolitics drive markets… even more so than Ben Bernanke’s—and now Janet Yellen’s—proclamations.