Will tapering tame the market?

The Federal Reserve, through the Federal Open Market Committee (FOMC), has telegraphed its intention to taper the Fed’s quantitative easing program that has been in place since early in the pandemic. The Fed’s policy has consisted of monthly purchases of $80 billion in Treasuries and $40 billion in mortgage-backed securities. The program has been largely successful in aiding the economic recovery and keeping interest rates low, as the central bank’s balance sheet exploded from $4.3 trillion to $8.6 trillion.

In reaction to the looming taper, along with pressure from elevated inflation, Treasury yields have jumped to the highest level since April. Additionally, the 30-year mortgage rate shot to its highest level in over a year, at 3.25%. Equity investors have largely shrugged in reaction to the tapering conversation. While the market experienced six weeks of weakness and volatility, the S&P 500^® Index surged to a fresh record high last week despite significant challenges in supply chains, elevated inflation and slowing economic and earnings growth.

Looking at the longer-term trend, however, it’s reasonable to question the degree to which aggressive central bank policy and resulting liquidity has helped power the staggering equity market returns since the financial crisis. Over the past 12 years, we have seen the S&P 500 increase by 339%, while the Federal Reserve’s balance sheet has increased by 296%. That amounts to a correlation of weekly results at 90%.

There’s more to the equity market strength than simply the size of the Fed’s balance sheet, but the S&P 500’s price/earnings ratio has steadily increased over this period, currently trading at 21-times forward earnings. A slowdown (and ultimately elimination) of asset purchases could put a dampener on the level of liquidity in the system. This could additionally put downward pressure on equity market returns.