Until 2008, the Federal Reserve’s balance sheet (assets it purchases and holds for longer than an overnight loan via the repo, or repurchase agreement, market) sat at around $800 billion. It had maintained a fairly steady growth rate that reflected the size and shape of overall U.S. GDP for about 50 years.
Then, of course, the Great Financial Crisis happened in 2008 and 2009. As a result, the Fed exercised its power as “lender of last resort” to buy mortgage-backed securities, government bonds, and select corporate bonds. It was all part of the means to bail out the U.S. economy.
As a result, the Fed’s balance sheet grew from $800 billion to over $4 trillion by 2014. That’s a whopping 400% growth rate in just six years.
The Fed’s attempts to “normalize” its balance sheet – going back toward the $800 billion or so it was at until 2008 – by selling assets back to the open market resulted in a series of market “taper tantrums.” Stocks crashed more than 10% each time the Fed tried to normalize since 2012.
As it turns out, the Fed never had a chance to normalize.
In early 2020, COVID-19 hit. Unemployment spiked to 45 million. The U.S. economy contracted by 30%. And thousands of businesses went broke.
Central banks around the world, from the U.S. to China to the European Union, were compelled to step in yet again. They purchased assets again. This time, the assets again included MBSs, government bonds, and corporate bonds. But they also included bond ETFs, covering key sectors that the Fed felt needed indirect financial support.
Today, the Fed’s balance sheet is well over $7 trillion.
But, arguably, it has been effective. The unemployment rate is now back below 7%. The economy had its biggest growth rate in the last quarter, growing 34%. And businesses have started to rebound.
As a result, U.S. stocks have skyrocketed since April. The S&P 500 and Nasdaq have since both hit new all-time highs.
This leads us to ask: What impact has injecting so many trillions of dollars into the economy had on the markets?
Well, we have an answer. And it isn’t one most economists (or long-term investors) are happy to hear. Société Générale (SocGen) economists Sophie Huynh and Charles de Boissezon have examined flow of funds. They looked at “Main Street” investor inflows versus those of institutional investors engaged in Fed buying programs. They estimate that half of the current value of the S&P 500 is due to the Federal Reserve’s quantitative easing (QE) programs.
It’s even more pronounced in the Nasdaq. SocGen estimates as much as 57% of the Nasdaq’s nominal value is solely due to the Fed’s programs. That should have every investor sitting up and taking note.
Free markets can fulfill their proper function of rational price-discovery only when they’re allowed to function without outside intervention. We’ve known for some time that Fed (and government) policies were propping up the financial sector, both in the U.S. and abroad. But seeing it quantified at more than half the stock market’s value is concerning, to say the least.
While investors have enjoyed powerful short-term returns, they have to wonder what happens when the Fed and other central banks finally limit or taper QE.
The short-term answer is: Don’t worry about it! The Fed knows it can’t do anything yet. It recently adjusted its inflation target, saying it will be comfortable if inflation is above 2% for an extended period. For now, it seems as though it’s comfortable with inflation being someone else’s problem to solve in the future.
This leaves investors facing a dilemma. Stay in the market and make the most of the Fed manipulation… or get out in preparation for the reckoning. Considering that many have forecast the final reckoning to come many times since 2008, and with stocks back to all-time highs, the strongest bet seems to be to stay in the market.
But it’s not a decision an investor should make without fully understanding the risks of doing so. After all, those that have called for that reckoning will be right one day. Unfortunately, we just don’t know when.