Tape versus taper
Newsflash: We are still in the midst of a pandemic. In fact, in the US, we are experiencing what many are referring to as The Third Wave. As of last night’s close, the S&P 500 was up by +20.57% year to date. “Isn’t that counterintuitive,” you are probably thinking. Well, technically speaking the US economy is currently experiencing a recovery expansion. Last year, 2020, that was when the pandemic was at its height… we were in a recession. Sorry, that won’t be intuitive either. The S&P500 racked in +16.26% for the year! Oh, and that recession, the worst since The Great Depression, only lasted 2 months… but it was deep. How did we get from there to here, the low to the high, that is? Of course, as in all things Economics and Capital Markets, it is complicated. Suffice it to say that science had a hand in it with treatments and novel vaccinations. However, the largest direct driver of this most recent, epic recovery was the US Government.
The Federal Government is tasked with fiscal stimulus in which budget decisions are undertaken by Congress and the President. Historically, these types of measures could include tax cuts, credits, or increased unemployment insurance payments. The pandemic, however warranted a completely different approach in tactics and in scale. In the darkest days of last year’s calamity Congress jumped into action with direct stimulus.
· Stimulus and Relief Package No. 1 – $8.3 billion, passed in March 2020, funded vaccine research and aided local governments in prevention measures.
· Families First Coronavirus Response Act – $192 billion, became a law on March 8, 2020, funded paid sick leave, expanded SNAP benefits, paid for diagnostic testing, and supplemented unemployment insurance benefits.
· The CARES Act – $2.3 trillion, signed into law on March 27th, 2020, provided one-time direct payments of $1200 per person and $500 per child (if qualified), expanded unemployment benefits including an additional $600 per week, provisioned for direct lending to affected companies, allocated to PPP program, supplemented healthcare providers, direct grants to state and local governments, and provided funding for schools and universities.
· Stimulus and Relief Package 3.5 – $848 billion, became law on June 5, 2020, expanded PPP benefits from CARES act.
· Stimulus Relief Package No. 4 – $900 billion, signed by President Trump on December 28, 2020, provided an addition $600 direct payment to all eligible Americans, expanded unemployment benefits, funded further PPP lending, provided assistance to airlines, funded further testing and tracing efforts, and emergency rent assistance.
· The American Rescue Plan Act of 2021 – $1.9 trillion, signed into law on March 11, 2021, provided $1400 direct payments to qualified Americans, increased child tax credits, expanded unemployment insurance, funded vaccine distribution, additional support for airline industry, and further expanded PPP benefits.
So, over the period of 1 year from March 2020 through March 2021 the US Government spent lots and lots of money to help turn the economy around by supporting business, struggling industries, the unemployed, and ordinary citizens. For the record, “lots and lots” is roughly $6.1 trillion… that is lots and lots. This was a series of fiscal stimulus packages like no other in history, providing direct cash payments to qualified Americans, hoping to either help out families in distress or to stimulate consumption in those that were fortunate enough to remain employed. As a frame of reference, the cornerstone of the Government’s response to the Global Financial Crisis was the TARP (Trouble Asset Relief Program) program, in which the Federal Government provided up to $431 billion to struggling businesses. At the time, it was a first of its kind and drew lots of debate in the years that followed. The aggressive and timely fiscal stimulus is credited with playing a large role in stopping the economic decline and helping propel the US Economy to even higher levels than prior to the pandemic. HOWEVER, fiscal stimulus was just one part of the equation for economic turnaround. The other part of the equation came from the Federal Reserve Bank.
When most of us think of economic stimulus, the Fed is the first thing that comes to mind. The US Economy is constantly expanding and contracting, and along with those waves come ups and downs in unemployment, inflations, and… gyrations in the stock markets. The Federal Reserve Bank has many responsibilities. Aside from serving as a bank to all banks and a bank regulator, the Fed is responsible for keeping watch over the economy. Specifically, the Fed has what has been referred to as a dual mandate, under which it is responsible to:
1. Keep inflation in check
2. Minimize unemployment
Keeping inflation in check is a part of its initial mandate, while Congress added mandate No. 2 in 1977 with the following:
… promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates…
While the mandate seems fairly straight forward, promoting both simultaneously is no small feat, as we have learned over the past 18 months.
It is December of 2019. President Trump has just announced the successful negotiation of The Phase One trade deal, ending a bitter battle of words and tariffs with China. The trade war had overshadowed global economic growth since it began in July of 2018. Things are looking up for economic prospects. The US Rate of Unemployment is 3.6%, a level not bested since 1969. Here is where things start to get interesting.
In Economics, there is largely accepted theory that states that as an economy approaches full employment, the inflation rate will begin to rise. The theory suggests an inverse relationship between unemployment and rising prices, implying that there is a trade-off between the two states. This theory was popularized by the famous economist Milton Friedman. Building on his work, economists further came up with the concept of the Philips Curve, which is the embodiment of the term Non-Accelerating Inflation Rate of Unemployment, which is often referred to by the mnemonic NAIRU. A simple way to think of it is the maximum employment rate at which there is minimal inflation. This is also referred to as the Natural Rate of Unemployment. ALSO referred to as a central banker’s dream scenario. Thinking of it practically, it becomes clear how that optimal environment can be elusive. When everyone is essentially working, there is more money to spend. More money to spend means demand for goods and services is high. That high demand leads to price gains, which is a more polite way to say inflation. The Fed must always be focused on striking that balance between those two mandates.
Now that we have that out of the way, let’s get back to December of 2019. We are at record low unemployment AND the annual rate of inflation (as per the Consumer Price Index) is right around the Fed’s 2% target. Many economists were beginning to believe that the economy was in a state of NAIRU. Let’s go a step further. Even though we refer to it as the dual mandate, you will notice that the Congressional mandate actually has a third mandate: moderate long term interest rates. In late 2019, 10-year treasury yields were just under 2%, having been in a secular downtrend since the mid-1980s. If we were to give the Fed a report card it would look as follows:
1. Keep inflation in check – ü
2. Minimize unemployment – ü
3. Moderate long-term interest rates – ü
Let’s take it one step further yet. Many economists believe that the Fed has self-assigned itself yet another mandate: Maintain a healthy stock market. It justifies this knowing that when the stock market is rallying, consumer confidence is high. High consumer confidence leads to economic growth which ultimately produces high employment (mandate No. 1). A year earlier, Chairman Powell noticeably shifted the Fed into a dovish stance ultimately turning what was the worst quarter for stocks since The
Great Depression. In the late summer, the Fed began to lower the Fed Funds Rate, ultimately easing it by a full 1%. The stock market responded by rallying some +9% through the end of the year bringing the S&P500 up by almost +29% for the year. So, adding to the report card:
4. Maintain a healthy stock market – ü
If this report card doesn’t merit a trip to the ice cream parlor, nothing will. In a little less than 3 months into the following year, the economy, unemployment, the stock market, indeed, the World was in absolute chaos as COVID-19 took hold.
An assortment of tools
The Fed’s most well-known tool to achieve this highly delicate balance is through the manipulation of short-term statutory rates, the most common one being the Fed Funds Rate. That is the overnight lending rate that banks charge between themselves when they borrow to maintain their mandatory reserves. When short-term borrowing costs go up for banks, they go up for all interest rate sensitive products including mortgages, car loans, credit cards rates, corporate bonds, and even treasury bonds. The increased cost of borrowing means companies and individual consumers can afford less. When consumers and companies spend less, price pressure diminishes and along with it, inflation.
Mandate No. 1 is a ü
But wait, less spending by consumers causes companies to be less profitable, which ultimately leads to poor performance and layoffs.
Uh oh, looks like the Fed might end up with an û for mandates No. 2 and No. 4
The quickest and easiest solution to that is to reverse course and lower rates once again. Is your head spinning yet? The Fed has gone through cycles like these time and time again since it first began using the tool in 1979. It worked like a charm through some very tumultuous economic eras… until the Global Financial Crisis which struck in December of 2007. By the time the recession ended in mid-2009 the Fed Funds Rate was for the first time in its history at 0%. In late 2008, the economy was still contracting, and the Fed decided to employ a new tool to stimulate the economy. In December the Fed would begin to purchase bonds in the open market. This would cause longer maturity yields to go down which would cause consumer and corporate lending rates to ease along with the shorter maturity Fed Funds Rate. Remember, lower borrowing costs are stimulative to the economy. This was known as quantitative easing, or QE. In the months that followed the Fed would bring to bear QE2, QE3, and Operation Twist, all designed to further stimulate growth. QE3 began in September of 2012. The economy had emerged from the recession and GDP was growing consistently around 2%. It was in May of 2013 when then-Fed-Chair Ben Bernanke told Congress that the Fed was considering the prospect of tapering the bond purchases which the markets had come to expect. The market’s reaction to the surprising admission was abrupt. The 10-year treasury note tumbled, causing its yield to jump from around 1.67% to around 3% in the ensuing 7 months. Interestingly, the Fed did not actually begin to taper until December of that year. Stocks briefly pulled back before rallying into the close of the year. The event became known as
The Taper Tantrum. The Fed did not begin to raise the Fed Funds rate until September 2015, almost 2 years after tapering began. Despite the fact that the Taper Tantrum was ultimately a bond market event, the name continues to haunt investors of all types. That brings us to the pandemic.
In March of 2020 when it became clear that the economy was in peril, the Fed sprung into action along side the Government. As the economic contraction was unprecedented, the Fed approached it with an unmatched Monetary Stimulus package. As expected, key interest rates were set to 0%. The Fed launched a number of previously unheard-of programs designed to provide liquidity to the banking system, failsafe programs for money market funds, and credit facilities for municipalities, to name just a few. Additionally, the Fed began to purchase $150 billion in mortgage-backed and treasury bonds per month. The goal of that resurrected Great Recession, QE-style instrument was the same as its predecessors: keep borrowing costs for companies and consumers low in order to stimulate consumption. Turning the clock forward to the late spring of the current year, it became clear that the economy had undergone a considerable recovery. Unemployment, while still slightly high was improving, GDP was growing, vaccinations were on the rise, the stock market was healthy. Things were beginning to look up. Everything except for one thing: Mandate No. 1, inflation. The rapid recovery and massive amounts of fiscal and monetary stimulus caused prices of goods to go up. The situation was confounded by troubles in the supply chain. A combination of the two was a toxic cocktail which caused a spike in inflation. How does the Fed fight inflation? It tightens monetary policy. The Fed can raise interest rates and, of course, curtail its bond purchases. If history provides us with some clues, the Fed will taper bond purchases after first warning us about it, and then ultimately, it will begin to raise rates. In fact, we don’t have to refer to history to know what the plan is. THE FED HAS TOLD US. Unlike Bernanke’s mere hint of tapering in May 2013, today’s Fed is quite vocal about the near-term likelihood of tapering. The Fed has made it clear that tapering is on the table and may occur as early as Q4 this year while interest rate hikes still remain further out in the future, like 2023. Knowing all of this has not removed the fear that taper tantrum may occur as it is currently the primary risk factor for the market, but with some slightly different nuances. Today, the fear is not if, but rather when the Fed will begin to taper. Additionally, it is not a pullback in bonds that investors fear, but rather a pullback in stocks.
What the taper means for stocks
Back in 2013 stock investors were not overly concerned with bond yields. Bonds going down in price almost always meant that stocks would go higher. Today investors have learned that yields and rates affect the theoretical value of the most treasured growth stocks. You know, the growth stocks that helped pull the stock markets off of their March 2020 lows to new all-time highs in just 5 months. As the economic recovery bloomed in the first quarter of 2021 and inflation began to pick up, bond yields rose rapidly, and their rapid rise derailed the growth stock rally which had stocks at historically over-valued levels. So, is it reasonable to assume that rates will rise with the pending taper, causing stocks to decline? Unfortunately, the answer is not so clear. To begin with, despite the increasing fear of tapering, bond yields have not risen much, if at all. Yields have certainly not behaved in the same way as they did in the 2013 Taper Tantrum. Perhaps, once the Fed actually begins to taper, rates may rise a bit as demand for bonds decline, but again, not likely on the scale of the 2013 move. Still, with stocks at record high valuations, is it time to consider selling your Apple, Facebook, Microsoft, NVIDEA, and Alphabet/Google in fear of an inevitable rise in yields? If you are a long-term focused investor the answer is simple. As long as the companies continue to grow revenues, earnings, and dividends while consistently offering a steady return on assets. I will now point to history. Since the Fed actually began to taper in 2013, the S&P500 rose by +74.73% through the end of 2019, prior to the pandemic. Apple, Facebook, Microsoft, NVIDEA, Alphabet piled on total returns of +322.51%, +236.64%, +355.01%, +1289.99%, and +140.07% respectively. Surely, we can accept those types of tantrums. Taper away, Fed.
Muriel Siebert & Co., Inc. is an affiliated broker/dealer of the public holding company, Siebert Financial Corporation, which also owns Siebert AdvisorNXT, Inc. Siebert AdvisorNXT, Inc. is a registered investments advisor (RIA) with the SEC and with state securities regulators. We may only transact business or render personal investment advice in states where we are registered, filed notice or otherwise excluded or exempted from registration requirements. Investment Advisor products are NOT insured by the FDIC, SIPC any federal government agency or Siebert’s parent company or affiliates.
You are being provided this Market Note for general informational purposes only. It is not intended to predict or guarantee the future performance of any security, market sector or the markets generally. This Market Note does not describe our investment services, recommendations or market timing nor does it constitute an offer to sell or any solicitation to buy. All investors are advised to conduct their own independent research before making a purchase decision. This Market Note is to provide general investment education and you are solely responsible for determining whether any investment, security or strategy, or any other product or service, is appropriate for you based on certain investment objectives and financial situation. Do not use the information contained in this email as a basis for investment decisions. You should always consult your investment advisor and tax professional regarding your investment situation before investing. The charts and graphs are obtained from sources believed to be reliable however Siebert AdvisorNXT does not warrant or guarantee the accuracy of the information. Any retransmission, dissemination or other use of this email is prohibited. If you are not the intended recipient, delete the email from your system and contact the sender. This is a market commentary, not research under FINRA Rule 2210 (b)(1)(D)(iii) and FINRA Rule 2210 (c)(7)(C).
© 2021 Siebert AdvisorNXT All rights reserved.