The Federal Reserve is printing less money – so why have markets hit record levels?

Last night the Federal Reserve, America’s central bank, did what it’s been promising to do for a long time now.

It started “the taper”.

What effect would this have? How would liquidity-glutted markets react to the news that the US central bank would stop printing quite as much money to buy US government bonds (and sundry other assets)?

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Why they promptly shot up of course.

A quick reminder of how markets work

The taper has begun. What’s a taper, in the financial context? If you prefer to ingest your definitions via the medium of video, just have a look here.

Otherwise, “tapering” is just a recently-invented term which describes a reduction in the amount of quantitative easing (QE - printing money to buy government debt or other assets) a central bank is doing.

It came into widespread use in May 2013. That’s when Ben Bernanke, who was the boss of the Federal Reserve at the time, started to talk about reducing the amount of QE the Fed was doing.

Note that Bernanke just talked about it. He didn’t actually start to taper for a little while after that. That’s because the markets threw a massive hissy fit in what became known as the “taper tantrum”. That bout of panic saw the Fed hold off on tapering until the very end of that year.

Fast forward to yesterday. The current Fed governor, Jerome Powell, said that the central bank will stop buying as much government and mortgage-backed debt right away. The Fed has been pumping $120bn a month into the market in all. From this month, that’ll fall to $105bn, then to $90bn in December, and by June, it’ll be done (assuming the pace is maintained).

So – the Fed is cutting the amount of money printing it’s doing. When it even mentioned the idea in 2013, markets swooned. Yesterday, both the Nasdaq and the S&P 500 hit new records, with each of them heading sharply higher after the news.

So why did stock markets pop higher this time around? In short, it’s because the Fed was less aggressive than expected.

One thing you must always remember as an investor is this: markets are constantly discounting the future. In other words, all of the market participants are constantly trying to work out what’s going to happen next, which leads to markets overall “pricing in” a version of the future.

Markets don’t always do this as efficiently as academia might suggest (if they did, we’d have the perfect prediction mechanism and, weirdly enough, markets would cease to work because there’d be no incentive to participate in them).

But they are generally pretty good at it.

If you’re struggling to wrap your head around this, just think about your own activity as an investor. Why do you buy any asset today? It’s because you think it’s going to appreciate in value in the future. You are placing a bet today which is based on your best understanding of an uncertain tomorrow.

If something is almost 100% likely to happen, then you are unlikely to be able to make money from it. For example, if a company receives a credible bid from a rival buyer, then its share price will almost instantly rise to reflect the price that the buyer promises to pay for it. The deal hasn’t completed yet – but the market “prices it in”, because it’s almost certain to happen.

This, by the way, is one reason why it’s not easy to beat the market. You have to find situations where the market is mis-pricing the future. That usually implies that you have to have an “edge” – you know something that the market doesn’t, which gives you high conviction that the market is undervaluing the odds of a certain outcome.

That’s contrarian investing. I wrote a lot more about this in my book, The Sceptical Investor (which you can get free if you subscribe to MoneyWeek today!)

The Fed is making it clear that it won’t worry about inflation for a while

But back to the topic at hand. The reason markets spiked is because they had expected the Fed to be more aggressive than it actually was.

For a start, the Fed stuck to the idea that inflation is “transitory”. This implies that interest rates won’t need to go up as rapidly or as sharply as some fear. Whether that’s the case or not (I don’t think it’s transitory) is not relevant here.

The point is that the Fed is sticking to the story that it doesn’t need to worry that much about inflation. That’s “dovish”. Moreover, Powell said that he expects this “transitory” inflation to last “until well into next year”.

That’s important. Most of us might think that “transitory” means “won’t last long”. Powell instead is using it in the sense of “this is inflation that we aren’t going to worry about”.

Powell also noted that while the Fed could adjust the pace of the tapering, “we wouldn’t want to surprise markets”. He also pointed out (again) that the Fed won’t be in a hurry to raise interest rates, even after the tapering is done.

Long story short, the Fed is still at pains to reassure investors that everything is just fine and that it’s got their backs. That state of affairs could last for some time. Hence the rise in stocks.

It’s also worth noting that earlier in the day, economic data had turned out to be extremely strong. That would have given the Fed a licence to err on the hawkish rather than the dovish side. So there was probably an element of relief that the central bank stuck to the script.

Anyway – what’ll now be interesting is how the rest of the world’s central banks act. The Bank of England is expected to raise rates (a bit) later today. One thing that could keep the bull market going is if the Fed lags the rest of the globe, which would help to keep the US dollar from rising too sharply, and thus encourage ongoing risk appetite.

But we’ll see what happens later today.