The Fed’s Self-Designed Chinese Finger Trap
by Zach Marsh on Jan 28, 2022
The January selloff continued in earnest this week. As of 9 am today, the S&P 500 is down 1.8% for the week, the Nasdaq 100 is down 3.6%, and the Russell 2000 is down 3.9%. This brings the losses month-to-date to 9.8%, 14.9%, and 15% respectively. Pretty clearly, the stock market is voicing its dissatisfaction with a change in Federal Reserve Policy. That change was again reiterated to the market on Wednesday when the Federal Reserve ended its two-day meeting. At the meeting the Fed announced that it will finish its asset purchases in March and begin raising interest rates to control an economy on the verge of overheating.
Much has been talked about Quantitative Easing over the last 14 years, but most people are unaware of the extent of the Federal Reserve asset purchase program and the overall impact on financial markets. We may understand that the Fed buys bonds--government, mortgage, and corporate debt obligations—under the guise of stabilizing the economy. But we may not truly understand the extent of this program and what its implications have been for asset prices generally. Below is a chart showing the growth of the Federal Reserve balance sheet since 2007, at the beginning of the financial crisis. The balance sheet is the total dollar value of all Federal Reserve assets.
The chart is scaled in millions of dollars. In 2007, the Fed’s balance sheet sat at $870 billion. As of last week, that number now sits at nearly $9 trillion. Where did this money come from; you may ask? Well, let’s just say they make it the old-fashioned way, they print it. Ok, technically, in our bureaucratic society, the US Treasury prints it, and the Fed spends it. But you get the point, it is made out of thin air. If you are wondering about the idea of an entity printing money to purchase its own debt, and what that portends for the value of its currency, all I can say is thank God for our reserve currency status. Being the reserve currency is like being modern day gold—it is the only thing keeping[ZM1] our inflation rate below 15%.
Back to the problem at hand. At its meeting on Wednesday, the Fed announced that purchases, read money printing, will end in March and the short-term borrowing rates will increase beginning at that time. However, they left open, what they plan to do with the $9 trillion already on their books. This number can and will go down if they do nothing at all. The bonds they hold will mature and they will receive cash back from the Federal Government and that paper cash will be “retired.” That is option 1. Option 2 is that they start selling off assets they currently hold, before they mature. This option will cause a greater increase in interest rates on longer dated bonds. This option will slow the economy at a greater pace. Option 3 is that they allow assets to mature and repurchase more assets at a reduced level. For example, $100 billion in notes mature and they purchase $500 million in new notes. As you can see, the Fed has a few options at their disposal when it comes to unwinding the balance sheet.
But then again maybe not. I’ve added another chart for your perusal. This one shows a scaled version of the Fed balance sheet vs the performance of the S&P 500 since January 2009.
While correlation does not imply causation, it is certainly easy to wonder how much of the valuation of stocks is reliant upon the balance sheet of the Fed. Additionally, while the Fed’s self-proclaimed mandate has nothing to do with insuring stock market prices, seeing the response in March 2020 by the Fed may beg to differ. Therefore, it remains to be seen if the Fed has as many options as they claim when it comes to unwinding their balance sheet.
After all, the Fed didn’t get very far the first time it tried to unwind its balance sheet. From 2015-2019 the balance only declined by 16.5% before they resumed adding to it. In fact, while Covid-19 seems to be convenient excuse for all sorts of poor behavior, the Fed actually began increasing its balance sheet before the pandemic was even a thing. From September 2019-December 2019 the Fed added 10% to its books. This, by the way, was when we were rocking record low unemployment, so its hard to really say what their justification was at that time. By July 2020, the balance sheet had grown over 100% in less than one year.
But here we are now, one and a half years later, and the Fed is going to start another unwinding process. If the above chart represents more than just a corollary event it is easy to understand why the market is unsettled. It is grappling with how it will stand on its own two feet without Federal Reserve assistance. The quandary for the Fed is obviously how to get out of this enormous position without crashing the stock market. For a Fed chair to have that happen on his or her watch is probably more than a bureaucrat can handle. Therefore, at some stage the sell-off in the stock market becomes a game of chicken. How far does the market go down before the Fed blinks? If I were to guess I assume it is still quite a bit lower from here. However, it will still be a lot sooner than the Fed needs in order to have this unwind be anything more than just a deckchair off the Titanic.
Thanks for reading,
Zach and Dave
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