The End of QE Didn't Kill The Bull Market. The Start of QT Won't Either

Summary: Quantitative Easing (QE) ended 3 years ago today. This was widely expected to mark the end to the bull market (post). Instead, US stocks have risen another 37%.

Why was this view wrong? In truth, the narrative about the Fed's policy has shifted over time as equities have risen. As late as 2012, QE was viewed as bearish. Into 2014, it was only the continued QE inflows that were considered bullish. When stocks kept rising after QE ended, the narrative shifted to the large Fed "balance sheet" and then to global central bank actions.

The Fed's policies have clearly led US equities higher, but not in the way that it has been popularly perceived. The Fed established the conditions for fundamental growth in consumption, investment, employment and corporate profits, creating the confidence in investors to place their cash into the financial markets. All of these factors have a strong causal relationship to share price that long pre-date 2009 and the QE programs.

The Fed will now embark on a reduction of its balance sheet (QT). This appears to be the most pivotal event facing markets in 2018. But it stands to reason that so long as the positive fundamental conditions continue, US equities can be expected to remain firm.

None of this implies that the US equity market will continue to appreciate without any interim drama. As noted in the charts that follow, investor sentiment is very bullish and equity valuations are very high. Since 1980, it has been normal for the S&P to correct by an average of 10% during the course of each year of a bull market. With the last correction of that magnitude starting 2 years ago, one of that magnitude, or larger, is arguably overdue in the coming months. That, not the tapering of the Fed's balance sheet, is the relevant risk for investors to focus on in 2018.

On September 20th, the Fed formally announced that it will begin to reduce its balance sheet, primarily by ceasing reinvestment from maturing bonds. This process is being termed "Quantitative Tightening" (QT) as it is the reverse of the bond buying program known as Quantitative Easing (QE).

QT will begin slowly, with a reduction of just $10b per month during the first 3 months. If there are no major market disruptions, then the pace of QT will be increased by $10b per month every quarter. To put that in perspective, $10b equals 0.2% of the Fed's total assets. By the end of the year, the Fed's balance sheet will have been reduced by less than 1% (from JPM). Enlarge any image by clicking on it.