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Published by dpbasic
James Paulsen: Is monetary policy still supportive for the stock market?

February 12, 2014
James Paulsen: Is monetary policy still supportive for the stock market?

February 12, 2014

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Published by: dpbasic on Feb 13, 2014
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Bringing you national and global economic trends for more than 30 years
Is monetary policy still supportive for the stock market?
Since the Fed recently began tapering its quantitative easing (QE) program and since mortgage rates and other long-term yields bounced from last year’s near record-setting lows, many investors believe monetary policy has now turned negative for the stock market. However, monetary policy is a joint effort implemented by both the Federal Reserve and by the laissez-faire marketplace. The Fed primarily controls reserve injections and the level of short-term interest rates while laissez-faire typically establishes the pace of velocity (how fast the money supply turns over creating economic transactions) and the level of long-term yields. Finally, both the Fed and laissez-faire combine to establish the slope of the yield curve. Some aspects of monetary policy have recently turned restrictive—the pace of reserve injection (QE) has slowed and long-term yields have risen. Other features of monetary policy, however, have not even yet turned positive for the stock market (i.e., money supply velocity is still declining as it has been throughout this recovery), still remain supportive of stocks (i.e., the continuation of an almost zero short-term interest rate), or have just recently turned accommodative (i.e., the slope of the yield curve has steepened significantly in the last year). Many investors are convinced the stock market is now des-tined to falter since the Fed has finally started to take away the punch bowl. However, could investors be under-appre-ciating the many facets of monetary policy and overlooking a couple which are just now starting to boost the prospects for economic growth and the stock market? We explored the possibility the economic recovery was finally being boosted by a rise in monetary velocity in an earlier note (see Economic & Market Perspective from November 11, 2013). This research piece examines another monetary force which has recently turned more supportive for stocks—a steepen-ing in the yield curve.
Are “rising” long-term yields helping boost economic growth?
Higher long-term interest rates are seldom considered a positive for the economy or the stock market. They can be beneficial, however, if they steepen the yield curve. Chart 1 il-lustrates a long-standing, fairly consistent and leading relation-ship between the slope of the yield curve and the pace of real economic growth. The dotted line in this chart represents the slope of the Treasury yield curve (i.e., the difference between the 10-year Treasury bond yield and the 3-month Treasury bill yield) and it is pushed forward (or leading the solid line) by one year. As shown, changes in the slope of the yield curve during the previous year have historically given a good indica-tion of the change in the pace of real GDP growth (solid line) in the ensuing year. In the contemporary period, of the three times the yield curve has steepened (in 2008, in late-2010, and most recently again it bottomed in mid-2012), each subsequently resulted, about a year later, in faster annual real GDP growth. Similarly, the flattening in the curve in both early-2010 and again in 2011 was followed by a significant slowdown in real GDP growth. As shown by the chart, while not a perfect relation-ship, most major shifts in real economic growth during the last 30 years have been preceded by changes in the slope of the yield curve.
conomic and Market
 James W. Paulsen, Ph.D.
February 12, 2014
Chart 1: Annual real GDP growth versus U.S. yield curve
Left scale (Solid)—Annual real GDP growthRight scale (Dotted)—Treasury yield curve pushed forward (leading) by one year
Economic and Market Perspective
Recently, after flattening since early-2011, the Treasury yield curve has steepened again since mid-2012 and rose signifi-cantly between May and September of last year. Right on schedule, the pace of real economic growth began improving by mid-2013 about one year after the yield curve bottomed. Encouragingly, as shown in Chart 1, the surge in the slope of the yield curve beginning last spring suggests even faster economic growth in 2014.While the Fed has begun to curtail its accommodative stance, laissez-faire monetary policy seems to be augmenting eco-nomic stimulus.
Yield curve support for stocks!
Chart 2 illustrates yield curve movements have also had a “leading” relationship with the stock market. The dotted line shows the change in the yield curve during the “previous 12 months” (i.e., whether the yield curve steepened or flattened compared to where it was a year earlier) and the solid line is the annual percent change in the S&P 500 Index during “the next 12 months.” Although not a perfect relationship, throughout the post-war era, how the yield curve has changed in the last year has been an important indicator for how the stock market fares in the coming year. The level of the yield curve does not appear to be as important as the “change in the slope” of the yield curve. When the dotted line is rising, the slope of the yield curve is steepening and this tends to be “followed” by positive performance from the stock market. In the past year, the yield curve has steepened by about 1% from year-ago levels suggesting a positive undertow for both economic growth and the stock market during 2014.
Chart 2: Yield curve movements and the stock market
Left scale (Solid)—Annual percent change in S&P 500 Stock Price Index in the next 12 monthsRight scale (Dotted)—Change in U.S. yield curve in previous 12 months
Economic and Market Perspective
Most believe the monetary environment is turning nega-tive for both the economy and the stock market. However, although the Federal Reserve is now tapering its QE program and bond vigilantes have begun to raise long-term yields, these represent only two aspects of “monetary power.Other facets of monetary policy, some of which have been restrictive during much of this recovery, are finally starting to become more supportive. Short-term interest rates are still near zero and remain uncommonly stimulative, for the first time in this recovery money supply velocity may be starting to rise and perhaps most importantly for 2014, the Treasury yield curve has steepened significantly in the past year. The Fed may be taking its punch bowl away just as laissez-faire policy officials are mixing a new batch. Indeed, while many may consider it absurd, is it possible monetary policy, in its entirety, is actually more accommodative today despite Fed tapering than at any time since the Fed worked to end the recession in 2009?The yield curve (shown in Chart 3) is a great example of a ma- jor monetary force controlled mostly by bond vigilantes which, until recently, has mostly been restrictive in this recovery. Between early-2010 and late-2012, the yield curve often flattened. The resulting contractionary force probably con-tributed (if not dominated) the frequent recovery swoons and stock market corrections which occurred during this period. Indeed, in line with the flattening yield curve move-ments shown in Chart 3, the stock market suffered almost a 16% correction in 2010, almost a 20% correction in 2011, and almost a 10% correction in 2012. While these economic swoons and stock market corrections may be due to chang-es in the Fed’s QE program as many believe, they may also be more related to severe yield curve flattenings invoked by bond vigilantes. In this manner, what is more important for the economy and the stock market today? The fact the Fed has begun to slow its QE program or the fact the yield curve has steepened by more and for longer than at any time since this recovery began in the summer of 2009? Overall, we believe monetary policy remains far more accom-modative today (based on a holistic view of its many facets) than most appreciate. Combined with other positive forces supporting the economy (e.g., less restrictive fiscal tightening compared to 2013, stronger balance sheets, strong pent-up demands, high homebuyer affordability, an energy indepen-dence dividend, a record-low real U.S. dollar exchange rate, considerable corporate dry spending powder, global economic synchronization, and the highest consumer confidence in five years), we expect real GDP growth of about 3.5% in 2014. De-spite a mild selloff at the start of this year, better-than-expect-ed economic growth should eventually push the stock market to new highs. We would not be surprised if the S&P 500 reaches close to 2000 sometime this year. However, we also suspect, “good news on the economy” may eventually become “bad news for the stock market.The first overheated fears of this recovery may ultimately result in a correction which perhaps returns the S&P 500 back to levels close to where it started 2014. That is, although this year might prove the best economic performance of the recovery, it may also produce a volatile and frustratingly flat stock market.
Chart 3: U.S. Treasury yield curve
10-year Treasury bond yield less 3-month Treasury bill yield

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