Practical analysis for investment professionals
01 May 2013

Is Fed Policy Responsible for the Rally?

Monday morning on CNBC, TrimTabs CEO Charles Biderman noted that “the Fed’s balance sheet is up a few trillion, and the equity market caps are up a few trillion. To me, there’s nothing else that’s going on.” The popular pundit line has been that QE (quantitative easing) is mainly psychological, but do the data support this claim? Is the reason for the steady move up in equity markets really just as simple as the Fed’s balance sheet expanding?

Although many charts have compared when the QE programs have started/stopped with the S&P 500 Index or 10-year U.S. Treasury yields, I can’t recall many that have used the Fed’s balance sheet size as a direct comparison. The benefits of this comparison are relatively obvious. The actual size of the Fed’s balance sheet reflects when securities have actually settled and the trades (excess reserves into the financial system and securities out of the system) have occurred. This is relevant and important to understand, given how the Fed’s purchases have actually materialized. Although QE3/infinity was actually announced in mid-September 2012, many of the purchases were made into the forward market (“to be announced” trades) and did not settle for a few months.

In plotting the S&P 500 market cap against the Fed’s balance sheet beginning in 2010, we find an 81% correlation between the two. If you look at time periods when securities are actually settling and the size of the balance sheet is growing, the correlation is even higher. For instance, since QE3 was announced, the correlation between the S&P 500’s market cap and the Fed’s balance sheet has risen to 88%.

Although I am not suggesting that this is the ONLY reason, it’s worth considering that the main reason for this big move up may have been the Fed’s liquidity. The chain reaction starts in the agency mortgage-backed securities and U.S. Treasury markets as buyers are pushed out and into riskier fixed-income asset classes. Each month that the Fed settles bonds, investors are left with coupon payments and portfolio runoff that needs to be reinvested into a market with fewer bonds. With the Bank of Japan recently bumping up its own QE program, removal of “safe” assets from the market has intensified. The link between liquidity provided by central banks and overall asset valuations seems pretty clear.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

About the Author(s)
David Schawel, CFA

David Schawel, CFA, is a portfolio manager for New River Investments in the Raleigh/Durham, North Carolina area. Previously, he managed a $2-billion fixed-income portfolio for Square 1 Financial, which he joined in 2008.

3 thoughts on “Is Fed Policy Responsible for the Rally?”

  1. Francisco Veiga says:

    Very interesting, thanks for sharing.


  2. botabox says:

    So here we are 30 days after your blog post. Fed has sent out the Hilsy “taper” trail balloon and suddenly Rates back up 50bp, and 30yr mortgages at 4%. And stocks don’t skip a beat. wow.

    Just my opinion here.. but I do not think rates are backing up b/c economy is improving that much.. I think the backup is due to anticipation of natural rate/price discovery absent (or less) fed meddling.

    What’s interesting to note is that tomorrow we get PCE deflator (fed’s fav tool to meas inflation) which is already at post recession lows… that will likely show falling aggregate demand (falling inflation) at the SAME time we are seeing a spike in interest rates.

    Might this be a perfect storm for deflation? time will tell.. nothing like raising a little cash here.

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