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CANEY CREEK REPORT - Quantitative Tightening

| June 25, 2018
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The talking heads on the business channels are having a field day with trade wars and tariffs. As usual, they speak with great certainty about “what happens in a trade war.” I would remind them that few of us were around when there last was a trade war.  And, the world was a considerably different place then.

The very small tariffs so far are being blamed for all kinds of things including rising consumer prices that might offset the positive effects of the tax cut. Of course, there is no mention of the offset from the increase in purchasing power as the result of the recently very strong dollar. In spite of the breathless rantings from the pundits, trade and tariffs are not the cause of the doldrums in the US stock market.

The real underlying problem is “quantitative tightening.” Recall that central bankers around the world started an unprecedented policy called quantitative easing early in this decade. They started buying bonds with money created out of thin air. The Federal Reserve did so much of this that they increased the size of the Fed’s balance sheet to over $4.4 trillion; five times as large as before the financial crisis. Other central bankers around the world did the same.

Now the economy in the US is chugging along nicely. Unemployment is well below 4%. Inflation is running above 2%. The Federal Reserve is now concerned about letting things get too hot to the point that they must tighten dramatically and perhaps cause a serious slowdown. So, they have begun raising short term interest rates. And, more importantly, they have begun to unwind quantitative easing. That means they are reducing their ownership of bonds and will be shrinking their balance sheet. In effect, they are doing quantitative tightening.

In the June quarter, they reduced bond holdings by $90 billion. In the September quarter, and in future quarters, they are scheduled to reduce holdings by $120 billion. Other central banks are scheduled to make similar moves starting in September. The world has been awash with money for years. That is changing. The markets are adjusting to a very different scenario going forward.

“Normalizing” monetary policy results in more competition for stocks. Suddenly, bonds are more competitive. A General Motors Financial bond due in 5 years yields 4.2% today. High quality tax free municipal bonds of 7-10 year maturity yield close to 3%. That is good competition for a dividend yield of 1.9% on the Standard & Poors 500 index.

The stock market is adjusting to this. And, in the very short run it must handicap the mid-term elections, increasing the level of uncertainty. I expect the stock market to remain stuck in a trading range of 2500-2900 on the S&P 500 until we get close to the elections in the Fall. But, I think there will be the usual yearend rally that will carry on through early January. Smaller and midsized stocks should be the best performers for the rest of this year.

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