Although the Federal Reserve lived up to expectations by maintaining its current policy stance in Wednesday’s meeting, there’s little doubt that the Fed will have to “taper” the pace of quantitative easing at some point in the future.
Right now, the consensus view is that tapering of any extent would prove destructive for the financial markets. However, a closer look at the Fed’s last two major tightening cycles shows that more restrictive monetary policy — while a distinct negative for bonds — might not be as much of a problem for stocks and gold as investors seem to expect.
The Lessons of History
To gauge what might be in store for the markets if the Fed scales back on QE, it helps to look at the past.
In the past 20 years, the Fed has tightened policy twice. While both occasions involved raising interest rates — whereas tightening now would take the form of reducing the monthly asset purchases occurring via QE — in all cases, the end result is the same: a withdrawal of stimulus.
The first interval of tighter policy began on Feb. 4, 1994, when the Greenspan Fed boosted rates from 3% to 3.25% — the beginning of an aggressive approach that saw the Fed funds rate rise all the way to 6% by Feb. 1 of the following year.
The second recent occasion of monetary tightening began on June 30, 2004, when the Fed raised rates from 1% to 1.25%, then proceeded to hike rates in quarter-point increments 16 times before finally stopping at 5.25% on June 29, 2006. This rate cycle was different from most in the sense that the markets and economy were emerging from the wreckage of the tech bubble, providing a much lower base for market performance than what we have today.
It isn’t accurate to measure the market impact of these moves by simply looking at performance from the first rate increase to the last, since investor expectations need to come into play. Instead, a better approach is to measure from three months prior to the first hike to account for the market’s anticipation of the shift.
Using this method, we can see how Fed tightening played out in stocks, bonds and gold:
|S&P 500 Index||10-Year Treasury||Gold|
|Nov. 4, 1993-
Feb. 1, 1995
|+2.82%||5.66% to 7.64%||$372 to $376.25
|March 31, 2004-
June 29, 2006
|+13.02%||3.84% to 5.20%||$423.70 to $589.25
It’s a small sample, to be sure, but it helps demonstrate that the conventional wisdom about what might occur in a tapering scenario might not be entirely accurate.
First, the idea that stocks necessarily have to get walloped by a reduction in QE isn’t supported by history. While shifts in Fed policy are almost certainly going to lead to higher day-to-day volatility, the end result for long-term investors might ultimately prove to be a period of subpar returns rather than an outright collapse. What’s more, bear-market predictions fail to account for the fact that the Bank of Japan is likely to provide continued support for the markets through its own aggressive quantitative easing, even if the Fed begins to taper.
Gold’s performance through the two tightening cycles also might be somewhat surprising. While the general expectation is that Fed tightening is a headwind for gold, the yellow metal held its own in the first cycle and surged in the second. Given how unhelpful QE has been for gold in the past two years, a tapering might not be quite as much of a headwind as investors are expecting during a one-to-two-year time frame.
The big loser in both tightening cycles was, of course, the bond market. Treasuries were hammered in each case, as would be expected in a period of rising short-term rates. While an end of quantitative easing might not have the same direct impact on the long end of the curve as an increase in the Fed funds rate, the 10-year yield has already soared from 1.63% on May 2 to 2.18% on June 18 — an indication that the bond market isn’t going to take the prospect of tapering in stride.
Bonds, much more than gold or stocks, are in the danger zone if the Fed is indeed on the cusp of reducing the pace of stimulus.
Is This Time Different?
The primary danger in reading too much into these numbers is that Fed policy is more important today than it was in either 1993 or 2004. With so much money having been pushed into higher-risk assets as a result of central bank actions, the potential for dislocations is higher now than it was in either of the past two tightenings.
Still, the stronger-than-expected results for both stocks and gold in the previous two tightening cycles can’t be overlooked. When viewed over a multiyear period, a gradual tapering might not be as destructive as recent market volatility would indicate.