Last quarter seems like an eternity ago. At that time I repeatedly noted how equity markets seemed to become dependent upon central bank liquidity, and became concerned when stocks rallied in spite of a plateauing Federal Reserve balance sheet. As we see stocks rallying once again on a massive expansion in central bank liquidity and the Fed balance sheet, it is time to take a fresh look at the relationship between stock prices to monetary accommodation.
Here is the type of picture that we were seeing in February. As a reminder, the Fed began expanding its balance sheet last September in an effort to forestall troubles that were manifesting in the repo market. As various providers and consumers of financing experienced difficulty using repurchase agreements to finance their lending and borrowing activities, the Federal Reserve stepped in to backstop them. Since many of those borrowers used that financing for leveraged investing, financial markets bounced accordingly:
We noted that there appears to be about a 2-3 week lag between a balance sheet bump and a move higher in the S&P 500 Index (SPX), and became concerned that a plateau in the size of that balance sheet could portend difficulties for stock investors. That concern proved to be correct, though of course for entirely unexpected reasons.
With COVID-19 ravishing the world and its economies, the world’s central banks responded in the only way they could, by expanding their financing facilities and backstopping a wide range of credits – many of which became immediately troubled as the health crisis became and economic catastrophe. The most recent rise in the Fed balance sheet dwarfed that of the previous move. The balance sheet increased by about 10% in the 6 months between August 2019 and February 2020. Compare that to the roughly 30% jump that occurred over the subsequent two months:
As before, we saw a roughly 2-3 week lag between the monetary accommodation and a positive reaction from the stock markets. The bounce in the markets was much sharper than the rise in the prior period. That is somewhat to be expected, since the indices were more depressed when the Fed began their moves and the liquidity injection was enormous
I included the NASDAQ 100 Index (NDX) in the second chart because market capitalization indices, like SPX and NDX, are becoming increasingly dominated by a small cadre of mega-cap technology stocks. Seven companies, Microsoft (MSFT), Apple (AAPL), Amazon (AMZN), Facebook (FB), Alphabet (GOOG, GOOGL), Intel (INTC), and Netflix (NFLX) comprise over 20% of SPX and about 50% of NDX. With those names accounting for much of the performance of SPX, it seems necessary to include NDX in any discussion of market performance. While I find it unusual and ultimately worrisome that market leadership is highly concentrated, it is important to consider an index that more closely mimics that leadership.
We are now faced with new questions:
- Will the steady decline in Fed purchases of Treasury securities affect the growth of its balance sheet, and will a lack of growth (or a decline) ultimately affect equity prices. The chart shows a declining rate of growth in the Fed balance sheet over the past two weeks. While it is certainly too early to call that a trend, we will need to monitor any changes when the figures are released on Thursday afternoon. In the meantime, we can clearly see the Fed is actively reducing its Treasury purchases:
- Are equity markets requiring ever more stimulus? I fear they are addicted to central bank liquidity. As they increase their dependency on central bank accommodation, will equity investors require ever larger liquidity injections to maintain their enthusiasm?
- Is central bank liquidity allowing investors to ignore ever increased dangers? The repo crisis exposed major cracks in the markets’ mechanisms for funding their activities. The Fed covered those cracks by substituting their activities for those of the markets. It was a monetary response to a monetary crisis. Now we are seeing a broader crisis causing detriment to the financial markets. While the Federal Reserve is responding to the extent of their abilities, we need to wonder whether the current monetary and fiscal responses will be sufficient in the longer term.
For further reference:
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