For the first time since 2014, when the Fed ceased its third round of quantitative easing (QE) via asset purchases of Treasuries and mortgage-backed securities, the Fed’s balance sheet is once again on the rise. Since last September, the Fed’s balance sheet has grown by almost $400 billion, while the S&P 500 has rallied by nearly 13 percent, setting 34 new record highs in the process.
Naturally, skepticism abounds with respect to the legitimacy of this latest rally, as it has correlated nearly perfectly with the expansion of the Fed’s balance sheet—while debates centered on whether the Fed’s latest round of asset purchases is a form of “quantitative easing” that is boosting markets rage on.
This was a common narrative during the early part of the post-financial crisis period, as stock markets were highly correlated with the Fed’s balance sheet and each round of quantitative easing and that stocks were only rising because of the actions of the Fed. The second narrative was that as soon as the Fed stepped away it would be time to get out of markets without the Fed’s support. Of course, that proved not to be the case as the S&P 500 eventually carried on its merry way as economic and earnings fundamentals continued to improve.
Now, as was the case then, we would recommend that investors not take their investing cues from the Fed’s balance sheet. The Fed has certainly moved to provide support for markets and the economy in recent months, but this latest balance sheet expansion is more technical in nature than it is stimulative, in our view, and there may be other factors at play.
The Fed began buying short-dated Treasury bills last fall amid signs of stress in the repurchase, or “repo,” markets, an indication of liquidity issues in the financial system. This differs notably from the QE programs of the past where the Fed was buying longer-dated securities and other assets in an effort to push yields down.
The latest balance sheet expansion is simply a reflection of—and necessitation for—the implementation of monetary policy under the Fed’s new regime of excess bank reserves in order to keep short-term interest rates within the Fed’s target range of 1.50 percent to 1.75 percent.
The key point is that the Fed’s balance sheet will likely never return to pre-crisis levels that were below $1 trillion and that this is now the norm. We believe the Fed will continue to build a buffer of excess reserves in the financial system via Treasuries to be purchased through June of this year, and that the balance sheet will then continue to grow “organically,” as it always has in line with demand for currency and other factors—taking it beyond even levels seen in the aftermath of the financial crisis.
But this week Federal Reserve Bank of Dallas President Robert Kaplan was the latest to weigh in on the idea that the Fed may be behind the rally in risk assets. He voiced a concern that the combination of recent rate cuts, the Fed’s commitment to keep policy rates on hold, and the expansion of the balance sheet “are contributing to elevated risk-asset valuations. And I think we [the Fed] ought to be sensitive to that.” To be sure, Fed Chair Jerome Powell, for his part, has been adamant that balance sheet expansion has not been adding stimulus to the economy. While minimal inflationary pressures give the Fed room to be patient, we expect that financial stability concerns will be a more frequent topic for Fed officials in the weeks and months ahead.
Breaking up is hard to do
Beyond the Fed’s balance sheet, though perhaps somewhat related to the current stance of Fed policy, is the lack of a threat posed from U.S. Treasury yields that may be helping to support risky assets, including U.S. equity and credit markets. The benchmark Treasury yield has held below two percent since last August, even as the global stock of negative-yielding debt has declined sharply amid a modestly improved global growth backdrop, breaking a relationship with global yields that had been in place for over a year.
We would focus more of our attention on this dynamic than on the progression of the Fed’s balance sheet. While low Treasury yields may be a positive for stock markets and valuations, the Treasury market appears to be pricing in a somewhat more subdued economic outlook than stocks currently are, even as the global outlook is improving.