Bloomberg TelevisionEveryone’s talking about the “taper.”
This is the prospect that the Federal Reserve will reduce its current bond purchase program, which could potentially cause interest rates to rise.
There’s a popular idea out there that the stock market’s rally in recent years has largely been driven by the Fed’s loose monetary policies.
But what if it were to tighten those policies? What if the Fed began to “taper” its bond purchases? Would this be bad for stocks?
“The beginning of a Fed tightening cycle is bullish far more often than not,” argues Deutsche Bank’s David Bianco in a note to clients this week. “It is only when tightening continues into a late cycle environment that it becomes risky. Contrary to popular belief, the party really starts when the Fed puts through its first hike. The punch bowl is removed when the curve inverts or inflation runs hot. Stock market dips on early hikes should usually be bought.”
Bianco is reiterating thesis of his lengthy January 13 note titled “Don’t Fear Interest Rate Normalization.”
He takes a close look at what the stock market did the last 15 times the Fed embarked began tightening its grip on monetary policy:
The party is best in the early hours…
Of the 15 tightening cycles since 1965, the S&P 500 continued to advance without correction during the “early-cycle” portion of the hikes all but 3 times: 1971, 1977, and 1994. The exceptions in 1971 and 1977 were when the Fed hiked early post recession on high inflation. These two stands against inflation were far too weak and required a much stronger follow-up attack in 1982.
The Fed briefly, but aggressively, hiked rates in the 1974 recession on runaway inflation. While we don’t consider this an early cycle hike (given inflation and that a new cycle never began) this crashed the stock market with back-to-back bear markets with a Feb to early March 10% rally in-between (1973-74 crash).
In 1994, the Fed hiked in response to falling unemployment that was approaching an uncertain NAIRU estimate at the time near 6%. This proved to be too hawkish. This and follow on hikes came as a big surprise to investors at a time when carry trades were very crowded and forced disorderly unwinds.
….but don’t stay too late
Of the 15 tightening cycles, we consider 11 to have started in a late cycle period or continued into late cycle. The 4 that started and stayed in early cycle are: 1971, 1977, 1983, 1994. These 4 were soon after recessions, occurred with a positive curve, albeit inflation plagued the 1970s market, as discussed.
The 11 tightening cycles that start late or continue into late cycle are: 1965, 1967, 1972, 1974, 1980, 1982, 1987, 1988, 1997, 1999, 2004. We mark off when these tightening cycles move into late cycle hikes based upon the yield curve in Figures 42-45. The early cycle portions of these hikes were safe, but the late cycle portions saw 3 corrections (1967, 1982, 1999) and 3 bear markets (1966, 1973-1974, 1987) and just 4 uninterrupted bull markets over the next 6 months (1980, 1988, 1997, 2004). The 1981- 82 bear market occurred mostly before the Jan 1982 rate hike. We counted the 1973-74 crash as 1 bear over 2 hike cycles. The best Fed engineered mid cycle soft landings were 1985 and 1995.
He’s currently tactically bearish, and his year-end and 12-month targets for the S&P 500 is a modest 1,625.
But his bottom line is that Fed tightening won’t break the stock market.
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