Central Bank Balance Sheets – Here And Abroad

I have been discussing my assertion that equity investors need to keep a sharp eye on weekly reports about the size of the Federal Reserve’s balance sheet. (See Update on the Fed’s Balance Sheet and A Blast from the Past from the Fed, among others.) Today is an appropriate time to take a fresh look.

The most recent report from the Federal Reserve, released last Thursday after the markets closed, continues to show a broad sideways move despite a slight uptick last week:

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When we see a divergence in a long-standing pattern, we try to determine whether that divergence shows a full break in that pattern or something more spurious. It is too early to conclude either that the size of the balance sheet has reached a plateau or that the S&P 500 Index (SPX) is continuing to follow the size of that balance sheet, but the speed with which SPX recouped its coronavirus-related losses seems out of character based on recent results.  With that data inconclusive, we start to look elsewhere for causality.

That search brings us to China, where we see the following data:

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(Click on image to enlarge)

It is typical for the People’s Bank of China (PBOC) to add liquidity around the Chinese New Year, but this year was far from typical. The coronavirus struck just prior to the lunar new year, and the PBOC is clearly going to great lengths in its attempts to offset the virus’ drag on the Chinese economy. With large portions of the country under quarantine, the PBOC is doing its best to minimize the impact upon a heavily indebted economy.

As with any other economic question, it raises multiple follow-ons. Among them:

• How much is the Chinese monetary stimulus affecting assets outside their border? My suspicion is that the recent decline in US Treasury yields and the rise in bitcoin are at least indirectly related to that stimulus, and it would not surprise me if one could find conclusive links to world equity indices. At a minimum, the Chinese stimulus could offer a rationale for the apparent divergence between the flight to safety and economic weakness implied by the bond market and the sanguine economic expectations baked into record stock prices.
• What happens to the monetary stimulus when the virus runs its course? It is customary for the PBOC to remove some of their stimulus after the holiday season, so markets take it in stride when that occurs.It remains to be seen whether the PBOC will be able to remove such a huge injection of money without shocking risk assets.

The most pressing question remains unanswerable right now – how much of a human and economic toll will result from coronavirus? The ultimate answers to the previous questions depend on how quickly the Chinese and global economies can recover from the supply shock caused by virus and governments’ responses to it. If the Chinese economy rebounds quickly from the virus’ effects, there is a distinct probability that the PBOC has overstimulated. There is also a risk that the PBOC slams on the brakes if it fears overheating the economy. And there is the risk that the economic effects last long enough to outweigh the central bank’s accommodation. 

Global economies and markets have been ever more intertwined over the past decades. It seemed unlikely that an outbreak in one corner of the world could have a profound influence on monetary policy throughout the globe, but this now how the world works.