The Federal Reserve and Equities
My regular readers have seen me discuss for some time the impact of monetary policy on the stock market. The chart at right illustrates how prior to the financial crisis and its resulting series of quantitative easing programs, there was no correlation between the assets of the Federal Reserve and the S&P 500. In August of 2008 the Federal Reserve began the first of its expansive monetary policies and the impact that speaks for itself. The stock market now has a 90% correlation with the Fed’s balance sheet, creating what one of our favorite analysts, David Rosenberg, refers to as the Potemkin rally.
When the Federal Reserve buys securities, such as treasury and mortgage bonds, it buys them from banks. The payments to the banks are then added to bank reserves, which can then be lent and re-lent in the fractional reserve system. (Click here for a quick primer on how our fractional reserve system works.) Historically this lending and re-lending resulted in an increase of about $70 in the money supply, (as defined by M2) for every additional dollar in reserves. With the current level of deleveraging, (reducing outstanding debt) occurring in the economy and with banks understandably nervous about lending, each new dollar in reserves has only boosted M2 by $1.4 for every additional dollar in reserves since the QEs began in mid-2008.
Research by Ken Rogoff and Carmen Reinhart, among others, revealed that the deleveraging cycle that occurs after a financial crises normally takes about 10 years, so we are likely only halfway through this process. All those excess reserves at the Fed, now totally about $2 trillion, aren’t likely to be able to spur significant growth as long as the private sector is continuing the deleveraging process.
Bottom Line: Since the financial crisis the stock market has been highly correlated with the balance sheet of the Federal Reserve despite the declining impact of Fed actions on the real economy. Changes in monetary policy which could reduce these reserves continue to dominate the market’s attention with significant market volatility driven by comments made by Federal Reserve officials.
