The Fed Is No Longer As Accommodating As Many Think


Chief Strategist at Interactive Brokers

Please consider the following chart.  The data comes from a report by the Federal Reserve that is released weekly on Thursdays at 4:30 PM Eastern time, entitled Factors Affecting Reserve Balances – H.4.1.  It is important to examine data carefully, especially when it conflicts with popular narratives.

Seemingly every market commentary points to the Fed’s accommodative stance as a justification for higher stock prices.  The data tells us that we may be seeing a limit to that accommodation.

The white starred line is the size of the Federal Reserve’s balance sheet (near right axis). The orange line is the weekly change in absolute dollar terms (near left axis), while the blue line is the weekly change in percentage terms (far left axis).  The red line, for comparison, is the S&P 500 index (SPX, far right axis).

Source: Bloomberg

It had become apparent that the pace of growth in the Fed’s balance sheet had slowed considerably from the remarkable pace that we saw in March.  That seemed self-evident, as such growth was the result of extraordinary new measures in response to extraordinary new circumstances.  Compare the bump in March 2020 with the smaller bumps in September 2019.  Those increases came as the Fed backstopped the repo markets.  They seemed huge at the time, yet now seem like hiccups.

But it is more concerning that the growth has not just slowed – it has stopped.  Note the summer of 2019 period, when the balance sheet was stagnant or declining slightly.  SPX meandered accordingly, with an autumn decline arrested by the liquidity injections that we referenced earlier.  I find it hard to believe that a more highly priced and valued equity market, one that still lacks clarity about the pace of economic recovery and corporate earnings, would be able to sustain an advance under those same circumstances.   The 6-week period of balance sheet stagnation is far from statistically significant, but we must be prepared for the ramifications if it persists.

We can see from the chart that monetary injections appear to operate with a 2-3 week lag.  Even “Don’t Fight the Fed” is not immediately adopted.  It is not as clear how long it takes for the market to pay attention when the tide turns.  Stock markets enjoy positive momentum, so there is less inclination for them to decline when monetary accommodation slows.  This chart, however, should give investors reason to reconsider the popular narratives about the Federal Reserve, and perhaps some time to consider its ramifications.

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