A Blast From The Past From The Fed

Oh so many years ago, when I started in the business, Wall Street came to a halt on Thursday afternoons. Monetary aggregates were the economic indicators to watch and they were released by the Federal Reserve on Thursdays at 4:30 PM. Markets lost their fascination with items like M2 and the Monetary Base several years ago, but I assert that the weekly Fed release contains the most important indicator for our current market environment – the Federal Reserve Balance Sheet.

One can attribute the equity market’s performance to myriad factors, but I believe that the supercharged rally of the past few months is a direct result of the Fed’s effort to stabilize the repo market. The shaky repo market required the Fed to purchase billions in short term US Treasury notes, and while the Fed denies that they have embarked upon another round of quantitative easing, the equity markets have reacted as though QE4 has begun.

The charts below show the relationship between the Fed balance sheet and the S&P 500 Index. Equity markets can and do rally while the Fed shrinks its net assets, though a rising balance sheet acts as a tailwind to equities, supercharging their rise.

(Click on image to enlarge)

It is obvious that the Federal Reserve had a significant role in arresting the panic of 2008 and much of the ensuing rally was accompanied by an expanding Fed balance sheet. Equity markets were able to continue advancing despite a plateau in the balance sheet thanks to an earnings recovery and later the promise of fiscal stimulus from tax cuts. Interestingly, the balance sheet continued to contract even after the Fed appeared to pivot its monetary stance in late 2018. 

The effects of that balance sheet contraction were largely ignored by stock markets in favor of the Fed Funds target rate cuts throughout last year, but those effects must have been felt in the repo markets. It remains unclear why the Fed felt compelled to step in to stabilize that crucial funding market. Theories range from the technical, like a shortage of high-quality collateral, to the dire, like a large bank in crisis. Regardless, stock markets focused on the flow of money rather than obsessing over the reason for the Fed’s largesse. This is obvious in the 6-month chart below:

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Disclosure: The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the ...

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