The Big US Taper Tantrum

The Great Depression was a global economic depression that originated in the USA in 1929. Just one year before this significant event, a group called Famous Myers Jubilee Singers released the spiritual song, Dem Bones. This song was made even more famous a few decades later by the group Delta Rhythm Boys, but today it is better known as a children’s song and nursery rhyme:

“The toe bone’s connected to the foot bone

The foot bone’s connected to the heel bone

The heel bone’s connected to the ankle bone

The ankle bone’s connected to the leg bone”

For those of you who are not so familiar with it, this song explains how all the bones in our body are actually connected to each other.

I couldn’t help but think of this song as I was writing this report to explain to readers the real issue with the US economy. But to shed some light on how all the problems are connected, you will have to bear with me, as I have to start at the very beginning.

The “story” started more than 20 years ago. During the late 1990s, predictions that the so-called “dot-com bubble” would burst soon were on the rise. Following the 1997 Asian financial crisis and the mini-crash that followed in October of the same year, we saw some improvement, and the Federal Reserve (Fed) decided to increase interest rates six times between June 1999 and May 2000. The term “soft landing” started to do the rounds, which referred to the Fed’s plan to cool down the economy without any significant crashes. But the result was all but a soft landing. Die NASDAQ bubble officially burst in March 2000, and it didn’t stop there. After interest rates increased for the last time in May 2000, the NASDAQ not only declined by a further 67% between May 2000 and September 2002, but US economic growth (GDP) weakened significantly after that. In fact, the third quarter of 2000 saw the slowest GDP growth since 1992.

Graph 1: NASDAQ COMPOSITE – past 12-months vs May ‘99 to May ‘00 (sources: Refinitiv Eikon & PSG Wealth Old Oak)

Things went from bad to worse, and by March 2001 there was a full-blown recession that lasted for eight months until November 2001. That same year brought the 9 September 2001 terror attacks and the war in Afghanistan shortly thereafter.

Congress felt desperate, and on 9 June 2001, President George W. Bush signed the “Economic Growth and Tax Relief Reconciliation Act of 2001” (EGTRRA), which provided massive personal tax relief for US citizens. The Fed’s expansionary monetary policy also contributed to the recession’s end, and in January 2001 they started with a series of interest rate cuts. Make no mistake here. They knew that they were in big trouble, and they didn’t just cut interest rates by one or two percent. They literally caused the federal funds rate to decline from 6.5% to 1% between January 2001 and June 2003. This was done mainly in an attempt to stimulate the economy and increase liquidity. You will see later how this process repeated itself.

Graph 2: Fed Fund Rate between Dec ‘00 & Jun ‘03 (sources: Refinitiv Eikon & PSG Wealth Old Oak)

This contributed towards what later became known as the “housing and credit bubble”. With the US economy that started to show some growth shortly thereafter, they received large volumes of foreign currency from some of the fastest-growing economies in the world. This growth inflation paired with an incredibly low interest rate- and tax environment made accessing credit very easy, which in turn caused this very “housing and credit bubble”. In 2006 the housing bubble reached its peak, and not unlike the dot-com bubble six years prior, in 2007, it burst. As the US had not yet fully recovered from the previous crisis, they were now in even bigger trouble than before.

Once again, the Fed intervened. Seeing that other countries were now even more invested in the US, the FED and central banks, took aggressive steps to address this new crisis. Let’s be honest – if the USA was a company, this was as close to bankruptcy as you could get at this stage. The Fed’s reaction to this was twofold. Firstly, to create market liquidity and secondly, to establish macroeconomic targets through monetary policy (interest rate cuts).

Interest rates were cut dramatically yet again, but not down to the 1% to 2% levels we saw in the early 2000s. This time the federal funds rate declined from 5.25% to 0.25% in December 2008. We also witnessed the birth of Quantitative Easing (or QE program), which basically meant that the US started to print money to provide support to banks and then repurchased these loans onto the Fed’s balance sheet. The Fed announced the original program in November 2008 for $600bn.

That didn’t last very long, as in March 2009, the Fed decided to increase their balance sheet, and they announced that an additional $570bn in government-sponsored enterprise mortgage-backed securities would be purchased. In other words, they would throw new good quality money at very bad debt.

In a 60 minutes CBS News interview on 7th June 2009, the Federal Reserve Chairman, Ben Bernanke, said the same thing. To quote: “Well, this fear of inflation, I think is way overstated. We’ve looked at it very, very carefully. We’ve analysed it every which way. One myth that’s out there is that what we’re doing is printing money. We’re not printing money. The amount of currency in circulation is not changing. The money supply is not changing in any significant way.” In a follow-up interview on 5 December 2010, while being confronted with the fact that they were, in reality, printing money, his answer was: “Well, effectively, and we need to do that, because our economy is very weak and inflation is very low. When the economy begins to recover, that will be the time that we need to unwind those programs, raise interest rates, reduce the money supply, and make sure that we have a recovery that does not involve inflation.”

For the next four years, QE continued, and by then it had started to sound like the “Rocky” movie franchise (1, 2, 3, 4…). But the US got through the Great Recession, and at the end of December 2015, they decided to start with interest rate hikes, which was done relatively slowly. In September 2017, the Fed announced that they would begin with Quantitative Tightening (QT) – the process of reducing the Fed’s balance sheet.

Graph 3: Fed total assets vs S&P500 Index (sources: Refinitiv Eikon & PSG Wealth Old Oak)

Over the next two years, the Fed managed to reduce its balance sheet by $700bn, which caused sudden volatility in local markets (including the S&P500). But markets still managed to move forward somehow. During the middle of September 2019, the US repo rate suddenly “spiked and exhibited significant volatility” (Fed Notes). This gave the Fed quite a big scare, and they were fearful that QT may have broken the market. As a result, the QT process was stopped immediately. The Fed’s balance sheet increased by a further $400bn. And then Covid-19 struck.

I don’t need to explain what happened next as this is still very fresh in our minds. The FED decided to continue with economic stimulation to create even more liquidity. Not only has the Fed’s balance sheet grown by $4.7tn since the end of February 2020, but the amount of money in circulation in the US (M2 money supply) is 40% higher today. Over the same period, and with all this money circulating, we saw an increase in inflation in the USA (year on year) in January 2022 to 7.5%, which is the highest growth in 40 years.

At the end of last year, the FED announced that they would once again be starting a tapering process, and in February 2022, indicated that interest rates in the US must rise.

We always talk about all of these events (dot-com, recession, housing- and credit crisis, the great recession and Covid-19) in isolation, but if you take a step back, you will realise that “The toe bone’s connected to the foot bone. The foot bone’s connected to the heel bone…”.

Will the US manage to get itself out of this predicament successfully? Will the US market and even other world markets manage to emerge unscathed if they don’t? Former Federal Reserve Chairman Paul Volcker, who had to guide the USA out of stagflation in the 1970s, once said, “When you hear complaints about less liquidity, remember there is such a thing as too much liquidity”. To me, it seems as though the US has forgotten this.


The opinions expressed in this blog are the opinions of the writer and not necessarily those of PSG. The information in this blog is provided as general information. It does not constitute financial, tax, legal or investment advice and the PSG Konsult Group of Companies does not guarantee its suitability or potential value. Since individual needs and risk profiles differ, we suggest you consult a qualified financial adviser, if needed. PSG Wealth Financial Planning (Pty) Ltd is an authorised financial services provider – FSP 728

Schalk Louw

As Portfolio Manager at PSG Wealth Old Oak and with over 20 years’ experience in the investment industry, Schalk has consistently delivered solid returns to his clients and has certainly become one of South Africa’s most well-known strategists. He started his career in 1994 at the stockbroking company, Huysamer Stals (later ABN Amro). He joined SMK Securities in 1997, (later became BoE Personal Stockbrokers) and was later appointed as director and branch manager. In 2001 he co-founded Contego Asset Management and managed the company as CEO up to March 2014, after which he joined PSG Wealth Old Oak. Schalk has also become a regular household name with investors, with his reports being published in many of the national press. He completed his MBA in 2008.

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