How QE Tapering Will Affect The Stock Market


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Why Wall Street Is Concerned About How QE Tapering Will Affect The Stock Market

Federal ReserveMany traders and investors are concerned about how QE tapering will affect the stock market.  The incredible bull market that has rocketed stock market indexes to new all times highs during 2013 can be partly attributed to the Federal Reserve Quantitative Easing (QE) program that has served as a backstop to the stock market and has provided an artificial boost in economic growth and corporate earnings.  The broadly based S&P 500 stock market tracking index is up by approximately 150% since the March 2009 lows.

With Federal Reserve Chairman Ben Bernanke’s announcement in May 2013 that the QE program will be wound down starting in the later part of 2013, those who trade or invest in the stock market need to understand how QE tapering will likely affect stock prices going forward, since a change in liquidity provided to the economy by the Fed often affects the movement of stocks.

The old saying, “Don’t fight the Fed” has proven to be a wise piece of trading and investing advice.  The stock market usually increases in price when the Fed has easy monetary policies, such as low interest rates and/or Quantitative Easing, and tends to have a harder time increasing in price as the Fed tightens monetary policies by raising interest rates and draining liquidity from the banking system.  Eventually, increases in interest rates and the removal of liquidity from the economy, which are done to fight inflation pressures during economic expansions, lead to a recession, which in most cases causes a bear market sell-off to occur in the stock market.  A shift towards tighter monetary policies and the removal of the Fed’s QE stock market backstop could make it harder for stocks to continue higher.  This is why Wall Street is concerned about the Fed QE tapering.

What To Expect From The Stock Market When The Fed Tapers QE

Quantitative Easing.png
The Fed QE program, which has most recently consisted of buying $85 billion per month of long-term United States Treasuries and mortgage-backed securities (MBS), has kept long term interest rates artificially low and has injected liquidity into the banking system at an unprecedented rate.  QE tapering means the Fed will decrease the amount of long-term United States Treasuries and mortgage-backed securities that they purchase each month.  Initially, the decreases will be modest, likely on the order of $10 billion less per month in purchases; however, the Fed has stated that they intend to eliminate the purchases altogether over time, so eventually the stock market will have to contend with no Fed backstop and no QE providing liquidity to the economy.

Therefore, what should stock market traders and investors expect when the Fed tapers QE?  Nobody can be absolutely sure what to expect, due to the extremely complex nature of the world financial system and the stock market; however, using history as a guide, some reasonable assumptions can be made.  Fed Chairman Bernanke indicated that QE tapering will begin during the fall or early winter of 2013, if the economic data is strong enough to support tapering.  Market observers have taken his statement to mean that QE tapering will begin in either September or December 2013.

It is likely the announcement that QE tapering is underway will lead to a short-term stock market sell-off and an increase in interest rates.  However, the sell-off may not last very long since the Fed will only start QE tapering if the economy is strong enough to endure such actions.  A stronger economy inevitably leads to stronger corporate profits, which is ultimately what causes the stock market to increase in price, so in the medium term, the stock market can be expected to rally, as long as QE tapering does not cause the economy to stall and approach recession levels.

A look back at the historical performance of the stock market during periods of Fed monetary policy tightening indicates that the stock market has historically continued in bull market rally mode for a few years, as the Fed increases interest rates and/or drains liquidity from the economy.  This is because the Fed tightens monetary policy in response to strong economic growth, which translates into higher corporate profits and ultimately higher stock prices.  However, at a certain point, usually two to three years into the monetary tightening phase, higher interest rates and a lack of liquidity start to choke off economic growth, and the economy often slows down or goes into a recession.  This usually results in decreased corporate profits and a stock market sell-off that often reaches the threshold of a 20% sell-off that is considered a bear market.

What To Do When The Fed Tapers QE

Federal Reserve QE Tapering
While it is impossible to predict with total certainty how the economy and stock market will ultimately react to the Fed tapering QE, it appears that the Fed will only taper if the economy is of sufficient strength to endure higher interest rates and less liquidity, which means that any post-tapering stock market sell-off will likely provide a buying opportunity in the stock market.  In the long-term, another economic recession will undoubtedly materialize in the United States economy and cause the stock market to sell-off, but that could be years away and from much higher stock market levels, especially since the Fed will be quick to react to any significant decreases in economic growth and could reinstate QE and the stock market backstop.

It appears that the consensus among stock market observers and analysts is to buy a stock market sell-off that occurs in response to an announcement that Fed QE tapering has begun and to hold stocks for an expected period of economic growth.  Once back in stocks, traders and investors should monitor economic indicators for signs of an economic slowdown, as any slowdown or recession that materializes could cause the stock market to undergo a steep bear market sell-off.

Fed QE Tapering Will Also Affect Foreign Stock Markets

It is important for traders and investors to understand that the Fed QE tapering will not only impact United States stock markets, but will also stock markets and financial instruments, such as currencies, around the world.  With just the expectation that QE tapering will occur, many developing world economies have seen significant decreases in stock prices and the value of their currencies during the summer of 2013, as traders and investors have begun to sell their speculative holdings in developing world economies.

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One Response to “How QE Tapering Will Affect The Stock Market”

  1. Chitra says:

    The US currency continued to follow the outlook for Fed’s QE tampering that was constantly changing. QE tampering will impact the stock market.

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