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RENAISSANCE
VIEW
AUGUST 30, 2013
PUBLISHED BY: RFC INVESTMENT COMMITTEE
Could Fed Tapering Spur Economic Growth?
As you may know already, tapering refers to the Fed reducing its approach to quantitative easing (QE),
which currently entails monthly purchases of $85 billion in Treasuries and mortgage-backed securities
from financial institutions. The objective of quantitative easing is to inject liquidity into the financial
system, which will in turn be put to use as bank credit. For the process to work from a macroeconomic
standpoint, the banks selling securities and receiving this liquidity must use the funds to expand credit in
the economy (i.e. make loans) which, via the multiplier effect, will result in increased economic
activity...Econ 101. Unfortunately this has not been the case. At the end of December 2012, excess
reserves were roughly $1.46 trillion. In late July of this year, excess reserves were $2.03 trillion, an
increase of $572 billion. During the same period of time, the Fed bought an almost identical amount,
$574 billion, of securities from banks [i]. So the net effect on the economy from QE has been minimal.
Simplistically, all of the liquidity the Fed has injected into the financial system since the end of last year
has ended up back at the Fed in the form of bank reserves/deposits, and very little has found its way into
new bank loans. Certainly the Fed's QE buying has contributed to keeping rates low, which in turn has
somewhat helped the economy. However, in general, the liquidity stemming from quantitative easing has
generated little in the way of new bank lending.
Why are the banks not lending? Banks lend money long-term at higher rates and borrow money short-term
(i.e. deposits) at lower rates, and make money on the spread (difference between long-term rates and shortterm rates). Until recently, this interest rate spread has not been wide enough for banks to take the credit
risk involved with lending. We believe that is why we've seen weak loan growth in the banks' recent
earnings reports. As longer-term interest rates drift higher, the banks become more interested in lending,
especially if shorter-term rates remain low.
A common fear is that interest rates will rise when the Fed reduces and eventually stops its purchases, and
higher rates will choke off what little economic growth we do have. But, from an economic standpoint,
would higher interest rates be all that bad? Sure, mortgage rates would also rise so fringe homebuyers may
have to settle for buying less house, but mortgage rates are still relatively low historically. Long duration
bond funds may suffer, but wouldn't bond investors be happy to finally invest at rates that could generate
more substantial long term income? Further, wouldn't higher rates (if they translate into wider spreads for
banks), lead to more bank lending, which in turn would lead to more spending and stronger economic
growth? And wouldn't this economic growth be more appealing since it would be generated without the
Fed's security-buying blanket?
Corporate profits have remained strong for several quarters, however, much of that strength has come from
companies controlling costs, rather than from revenue growth. In fact, while 67% of companies beat
earnings expectations last quarter, less than half of those companies reported better than expected revenues
[ii]. In our opinion, this is not a sustainable model for economic growth and driving stock prices
higher. Eventually, revenue growth must reappear. Could Fed tapering be just what is needed to lead to
the higher rates that are attractive enough for banks to help spur economic growth and improve corporate
revenues and earnings?
As always, thank you for letting us serve you.
Sincerely,
Gary Orf, CFA
Chief Investment Officer
Renaissance Financial
[i] Federal Reserve Bank data, August 2013.
[ii] Zacks Investment Research, August 2013.
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operated. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be
replied upon by the reader as research or investment advice regarding any funds or stocks in particular, nor should it be construed as a recommendation to purchase or sell a security. Past performance is not guarantee to
future results. Investments will fluctuate and when redeemed may be worth more or less than when originally invested. Neither diversification nor asset allocation guarantee against loss, they are methods used to manage
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