Rhyme or Reason?

The December FOMC statement and SEP projections suggest that the Fed will be done with taper by end of March 2022. To get a sense of how the taper of QE4 may affect markets, we look at how various markets traded (i) in the three months leading up to the completion of taper, and (ii) the six-months following the end of taper. We follow the timeline provided by the New York Fed here and look at the returns of the S&P 500, U.S. Treasuries, Commodities, Gold, and the Dollar. We caution that our sample size of three is extremely small and that the results should be taken with a large pinch of salt. Nevertheless, we provided the data for illustrative purposes to get a sense of what one might expect in the 9 months ahead.

1. S&P 500 – mixed

The S&P 500 saw a net positive gain on average in the three-months leading into taper with the market higher in two out of the three prior episodes. In the six months post-taper, the market suffered 10-15% drawdowns in two out of the three prior episodes but ended roughly flat by the end of the six-month period.

Source. Refinitiv, Orthogonal

2. U.S. Treasuries – positive

Contrary to what one might expect, the end of Fed purchases of U.S. Treasury securities actually leads to an appreciation in the price of medium/long-term U.S. Treasury securities. In all three prior episodes, IEF (the 7-10 year U.S. Treasury ETF) returned around +2% on average in the three months leading into taper and just under +8% in the six-months following. In no case was the return negative in either the pre- or post- period.

Source. Refinitiv, Orthogonal

3. Commodities – negative

Not surprisingly, and in contrast to the U.S. Treasury markets, commodity markets uniformly traded lower across all three prior episodes, declining just over 5%, on average, in the three months leading into taper, and bottom between -12% to -30% post-taper, before leveling out.

Source. Refinitiv, Orthogonal

4. Gold – mixed/positive

Given that both gold and U.S. Treasuries share the trait that they are both beneficiaries of a flight-to-quality trade in a down market, the gold follows a similar pattern to U.S. Treasuries. Because a reduction in the money supply strengthens the U.S. dollar, on the other hand, it is not surprising that gold suffers from competing forces leading to a less convincing pattern. In the three-months leading up to taper, the performance of gold has been mixed. In the six-months following taper, however, there is a stronger pattern of gold appreciation with a peak that coincides with the bottom in the commodities market, suggesting that gold benefits from a flight to quality from riskier commodity and equity assets.

Source. Refinitiv, Orthogonal

5. Dollar Index – mixed/positive

Lastly, the U.S. dollar follows a pattern quite similar to gold. With the Fed turning off the printing presses, it is expected (and indeed part of its stated goal) to strengthen the value of the U.S. dollar, thereby combating inflationary pressures. The U.S. dollar appreciates by an average of roughly 3% in the three months leading up to taper, and another 5% in the six months following.

Source. Refinitiv, Orthogonal

Summary Allocation

To summarize our results, past episodes of QE taper suggest that (i) equity returns will be muted while exhibiting higher volatility (lower risk/reward), (ii) commodities will suffer a decline, (iii) defensive assets such as bonds/gold will outperform, and lastly (iv) the U.S. dollar will appreciate. Historic patterns suggest that the effect of QE taper will peter out roughly three months post-taper (roughly end of Q2 2022). One could draw also take a step further to speculate on follow-on effects from this macro analysis, such as potentially weak EM performance due to a rising dollar. Given that monetary policy is and has been the biggest driver of macro returns for the last two decades, we believe this analysis should provide a good starting point for determining a 2022 outlook and portfolio allocation — in short, stay defensive.