More on QE/real interest rates as the New Cash Rate (Just Brainstorming)

Regardless of whether a taper begins this year or next, I'll continue to discuss my reasoning as to why the Fed's tapering will be equivalent to a rising OCR and a full exit should have roughly the same effect as an inverted yield curve for financial markets. There are several reasons for this, some of which may occur whether the Fed tapers or not - these I will discuss here.

Early in the recovery, when most people did not understand the potential effects of excess reserves and demand for bank credit, it was in vogue to panic about inflation, and inflation was fairly strong during QE1 and QE2. Whether asset purchases had a large direct effect on inflation or not when QE was running - while possible - probably doesn't matter too much. What matters now is that even if it was QE that was driving reflation in consumer prices, this effect is dwindling. The latest round of QE, despite being prolonged and open ended, has seen a gradual trend downwards in inflation (Source: St. Louis Fed):

While interesting in itself, when combined with the fact that long rates have unambiguously risen under balance sheet expansionary QE programs (despite the question of whether or not QE is the direct cause), this has lead to some notable effects; a rising real cash rate; positive real yields on long term US bonds. In effect, the Fed is not finding it easy to maintain inflation or financial repression, and the longer QE runs, the more attractive treasuries become relative to equities and other risk assets due to multiple expansion and falling yield spreads. (Source: St. Louis Fed):

Again - whether or not QE is inflationary - at the moment it is not stimulating strong inflation and the cash rate cannot go lower - hence real rates are rising. A negative real interest rate is associated with strong asset price performance, as it rewards various forms of speculative behaviour and leverage, of course, the opposite is also true of a sharp rise in the real rate.

The problem for a continued rally is that the real rate is becoming less negative, long yields more positive and yields on equity indices are lower than yields on risk free US long bonds (which is normal, but strong capital gains are not usually associated with valuations as high as right now). I know where I would allocate more of my money when the Fed has stopped expanding its balance sheet, but I am probably more cautious (not momentum chasing) and see a lot of relative value in treasuries vs equities as we head further into this dis-inflationary environment. (Source: St. Louis Fed):

If QE does end I am of the belief that inflation will move at least slightly lower (surely not higher), leading to real interest rates that are only marginally negative. Since the cash rate will not rise soon, positive real rates might only come about via deflation, something I'm not going to suggest is about to happen, but I suppose it is possible. Real rates moving less negative is a form of tightening in my opinion, given that this bull market has been a beneficiary of strongly negative real rates. Can marginally negative real rates sustain this rally? I really have my doubts that the repression effects are strong enough.

But, thinking more speculatively, if the Fed does not exit, eventually rising risk free yields must attract investors back, not to mention associated variables like rising mortgage rates will hobble the housing recovery, so there is a lifespan on QE leading to risk assets rallying over risk free counterparts. Perhaps the reason many people don't agree with this is that they believe that QE lowers interest rates on treasuries and raises equity valuations. If this was true, as I showed previously, yields and the index could not be positively correlated when QE is running - but they are, so it's a source of confusion for me that this is still the conventional wisdom.

What I am hinting at here, is that the narrative that the Fed will not allow risk asset prices to fall does not hold water. The Fed evidently has less control over inflation than it would like, and it's asset purchase programs have the effect of making risk free assets more attractive over time - thus a risk asset rally should be self limiting in theory. Every bull market has a narrative for why valuations are justified, and this gets overdone, leading to high valuations. Previously accurate forecasters such as GMO are estimating roughly a zero real annual return on US equities for the next 7 years, due to current high valuations

What is the catalyst for these valuations to begin to correct? For me, a tapering would be the start, but more importantly a Fed exit will see investors demand treasuries strongly in a portfolio. This is one point I'm fairly sure on - when the Fed exits completely, yields will plummet precipitously.