Mark Sept. 18 on 2013 calendar

Friday, August 23, 2013, Vol. 37, No. 34

Last week, we discussed the recent upshift in the global economy. The next major moment for the market will occur on Sept. 18 when 65 percent of economists expect that the Fed will announce a “tapering” of its quantitative easing program. The movement in the 10-year Treasury bond interest rate confirms this expectation as rates have now climbed to 2.84 percent, up from 1.6 percent three months ago.

As a refresher, the Fed is purchasing Treasuries and mortgage-backed securities in an effort to bolster the economy and reduce unemployment. However, the linkage between large-scale asset purchases and job creation is largely anecdotal. The politically correct justification for long-term asset purchases is that lower interest rates will stimulate business lending and job postings. Unfortunately, with demand slack in the economy, cheap money doesn’t necessarily make investment projects profitable as lower expenses don’t matter much without revenue. Furthermore, limited demand for money naturally reduces the price of money. Even without Fed intervention, interest rate levels would be historically low. In fact, when the Fed has announced simulative policies in the past, rates typically increased in anticipation of better economic times. If this policy really isn’t about the cost of money, then what is it about?

The politically incorrect, yet correct, intent for quantitative easing was to increase asset prices. This strategy disproportionately benefits the wealthy, who also happen to be the ones that make the hiring decisions across the economy. With housing and stock values quickly rising, the population that owns investment assets finds themselves flush with cash and optimism. This “wealth effect” should encourage risk taking and investment activity and theoretically, job creation. This is the Federal Reserve’s version of trickledown economics. Quantitative easing was not about the cost of money, but the price of investment assets.

Housing prices nationally are rising at their fastest pace since early 2006. The S&P 500 index has averaged annual gains of 18 percent over the last three years. If you live in San Francisco, where median home values approximate $800,000, you have received a 25 percent return on your house along with a 21 percent return on your investment portfolio over the past year. Feeling good, Winthrop?

Should quantitative easing continue to inflate asset valuations, bubbles with consequences will form. Given that the linkage between quantitative easing and the unemployment rate is so inconclusive, winding down the program to prevent unintended consequences makes sense.

The Fed currently purchases $85 billion per month. The markets expect them to reduce purchases to $65 billion. Should they surprise the market and reduce to $45 billion, a large sell-off would occur. The wealthy would take losses, and the “wealth effect” transmission system would grind. Should the Fed cut to $75 billion, the markets would celebrate the Fed’s restraint and likely advance. At $75 billion, the Fed can have its cake and eat it too. They begin tapering stimulus while preserving their cherished “wealth effect” to support further hiring. Yahtzee!

Will rising rates lead to falling stock prices??? Tune in next week.

David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.