Convenient narratives are slow to die, even when there is evidence to the contrary. The narrative about an endlessly accommodative Fed remains firmly in place even though yesterday’s H.4.1 release by the Federal Reserve showed a fourth consecutive weekly decline to their balance sheet. Please consider the chart below.
Regular readers should find this chart to be familiar. The white line (near white axis) is the size of the Federal Reserve’s balance sheet in trillions, the jagged blue line (far left axis) is the week over week percentage change while the orange line (near left axis) above it is the weekly change in absolute dollars. The large red line (far right axis) is the S&P 500 (SPX) index. We can see how SPX roughly follows the size of the balance sheet – declining slightly last summer along with the balance sheet, moving up solidly when the balance sheet expanded 10% last fall and winter, and rocketing higher during the recent 30%+ expansion. The only major divergence was because of the clearly exogenous Covid-19 shock.
To be clear, this week’s decline is not necessarily all bad news. The Fed is largely out of the repo market, in which it needed to intervene last August. That began the round of autumn expansion referenced above. At this point it appears that banks are able to finance their positions without assistance. That is a positive to the banking industry and the financial system as a whole. Besides repurchase agreements, the other main contributor to the decline in the balance sheet was a reduction in swaps with foreign central banks. That would indicate a reduction in global stress as well. A global financial system that can function smoothly without support is clearly a goal of the Federal Reserve’s.
This also does not call into question the Fed’s vigilance if economic or financial conditions warrant further action. In common market parlance, this is often called the “Fed Put”. But remember, this is not a put option in any conventional sense. It presumably has no expiration date, and we can only guess its strike price. Bear in mind also that the Federal Reserve has never directly intervened into the equity markets. While equities tend to rally when the Federal Reserve loosens monetary policy, stock markets are not part of the Fed’s mandate unless they threaten broader economic or banking instability. I don’t doubt the existence of the “Fed Put”, but a Fed that is showing greater willingness to let the system function without direct intervention is not likely react to equity markets facing an ordinary market correction. What this means for investors is that they need to be careful about assessing their rationale for their positioning. If one expects a broadly improving economy that will result in corporate earnings growth, then one should invest accordingly in stocks that they believe will benefit. If one is basing their strategy upon the foundation of a relentlessly accommodative Federal Reserve that will intervene further if the market stumbles slightly or corrects by a few percent, then one should be reassessing their risk exposure in the face of revealing data.
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