The US stock markets dramatically surged mostly in a straight line since mid-October. This extraordinary rally started when the Federal Reserve announced it would resume expanding its balance sheet for the first time in years. The deluge of new liquidity from that quantitative-easing bond buying has again acted like rocket fuel for stock markets. After shooting vertically they are in real trouble when the Fed pulls back.
In early October the flagship US S&P 500 stock index (SPX) slumped to 2888. That was a mild 4.6% pullback from late July’s latest record high. The SPX was still having a great year though, up 15.2% year-to-date at that point thanks to extreme Fed easing. After the SPX had plunged 19.8% mostly in Q4’18 in a severe near-bear correction, the Fed pulled out all the stops to bring stocks back from the brink of bear-dom.
Panicking after helping spawn that deep selloff, in 2019 the Fed prematurely killed quantitative-tightening bond selling years early, shifted its future rate outlook from hiking to cutting, and slashed its federal-funds rate 3 times in 3.0 months! In late December I wrote a popular essay detailing all the Fed’s actions last year, showing how each directly boosted the US stock markets. But the coup de grace came in mid-October.
The Federal Reserve publishes meticulous records, including minutes from every Federal Open Market Committee meeting and transcripts from every speech by high Fed officials including the chair’s post-FOMC-meeting press conferences. So most of the quotations in this essay are copied verbatim right out of those official Fed documents. They shed light on the Fed’s motivation for rekindling QE bond monetizations.
In mid-September the SPX was hovering just over 3000 as the FOMC held one of its regular meetings which happen about every 7 weeks. The day before, the Fed stunned announcing emergency funding operations for the overnight repurchase-agreements market! Described as the plumbing behind the US financial markets, repo rates exploded overnight. They soared far above the federal-funds-rate target range.
The Fed chair Jerome Powell was asked about this at his post-FOMC-meeting press conference on September 18th. On money-market problems, he replied “we have the tools to address those pressures. We will not hesitate to use them.” One of those tools is quantitative easing, the Fed conjuring up new money out of thin air and using it to buy bonds. Fed officials euphemistically call this balance-sheet expansion.
On that same question Powell concluded, “we’re going to be assessing, you know, the question of when it will be appropriate to resume the organic growth of our balance sheet. And I’m sure we’ll be revisiting that question during this intermeeting period and certainly at our next meeting.” That was a big hint the first quantitative-easing campaign since QE3 ended in October 2014 was moving towards the launchpad.
As the Fed’s emergency repo ops continued daily, the SPX slid 4.0% over the next couple weeks. There was increasing talk that these temporary repo ops would have to morph into permanent open-market operations, another name for QE. On October 8th Powell gave a speech at the National Association for Business Economics’ annual meeting in Denver. He used that to pre-announce QE4’s imminent birth.
Referencing the chaos in repo-land, Powell said, “While a range of factors may have contributed to these developments, it is clear that without a sufficient quantity of reserves in the banking system, even routine increases in funding pressures can lead to outsized movements in money market interest rates. This volatility can impede the effective implementation of monetary policy, and we are addressing it.”
“Indeed, my colleagues and I will soon announce measures to add to the supply of reserves over time.” He even preemptively tried to argue that the Fed’s coming balance-sheet expansion wasn’t QE4! “I want to emphasize that growth of our balance sheet for reserve management purposes should in no way be confused with the large-scale asset purchase programs that we deployed after the financial crisis.”
After closing near pullback lows that day, the SPX surged 1.6% over the next couple days on hopes for a US-China trade deal. Trump declared a “substantial Phase One deal” had been made on October 11th. That drowned out a far-more-important announcement by the Fed, which was issued between regular FOMC meetings to downplay it. This “Statement Regarding Monetary Policy Implementation” birthed QE4.
While that was light on details, it did declare “the Federal Reserve will purchase Treasury bills at least into the second quarter of next year”. The New York Fed in charge of open-market operations released its own “Statement Regarding Treasury Bill Purchases and Repurchase Operations” to clarify what was coming. Incredibly this new QE4 bond buying would be in addition to the ongoing repo ops, not replacing them!
The NY Fed proclaimed “the Desk plans to purchase Treasury bills at an initial pace of approximately $60 billion per month, starting with the period from mid-October to mid-November.” And “the Federal Open Market Committee (FOMC) directed the Desk, effective October 15, 2019, to purchase Treasury bills at least into the second quarter of next year”. QE4 started at $60b per month of T-bill monetizations into Q2’20!
The SPX surged 1.1% that day and hasn’t looked back since. As of mid-January at best, it had soared a staggering 15.1% over just 3.3 months since that day Powell pre-announced QE4! Out of the 70 total trading days in that span, an incredible 28 saw the SPX close at new all-time-record highs! The world’s biggest and most-important stock index by far rocketed vertically with QE4’s Treasury buying underway.
This chart superimposes the SPX on the Fed’s balance sheet over the past several years or so. Key Fed developments are noted, including rate hikes and cuts, quantitative-tightening milestones, and of course QE4’s launch. Other key market-boosting Fed events are also highlighted, like it preparing to start winding down QT years early, slashing its federal-funds-rate outlook, and Powell implying rate cuts were coming.
(Click to enlarge)
The Fed played a major role in Q4’18’s brutal near-bear SPX correction, as I detailed in my recent essay on this. The Fed had hiked its federal-funds-rate target 8 times before the SPX rolled over hard, and QT’s slow ramp up was finally hitting full speed at $50b per month of previous QE bond buying being unwound. Just before Q4’18 began with the SPX at record highs, I argued the Fed’s QT was this stock bull’s death knell.
Starting at 1/5th that pace in Q4’17, QT would ultimately shrink the Fed’s balance sheet by 15.6% or $695.7b over the next 1.9 years. Quantitative tightening was executed by not buying newer bonds as some older ones matured, effectively destroying that QE-created money. At their QE-driven peak in January 2015, the Fed’s total assets had soared 402.6% or $3,617.5b over 6.4 years starting with 2008’s stock panic! Related: U.S. Moves To Bar Iranians From Investor Visas
The total balance-sheet decline by QT’s premature end in late August 2019 was $756.1b, merely 20.9% of the total QE. While the Fed didn’t give a target when launching QT, Wall Street Fed experts generally figured it would involve a half-unwind of QE. Yet the Fed barely got to a fifth-unwind after panicking when the SPX sold off. By the time it tapered off that QT effective bond selling, its balance sheet hit a 5.9-year low.
The Fed believed that late-August nadir spawned the subsequent repo crisis which began less than a few weeks later. But most repo-market experts I’ve read and heard seemed to disagree, blaming a major US bank slashing its cash reserves deposited with the Fed for triggering that repo chaos. Either way, those resulting blowing-out overnight repo rates defying the federal-funds-rate target range directly led to QE4’s launch.
As you can see above, the balance-sheet growth in recent months has been astounding. Provocatively the ascent profiles of the Fed’s assets and the SPX have been nearly identical. The Fed’s balance-sheet expansion has been enormous, soaring 11.1% or $415.9b at most over 4.6 months as of mid-January! The Fed publishes balance-sheet data weekly, current to each Wednesday close. Its growth is eye-popping.
In the first 18 weeks of balance-sheet expansion including the repo ops which filled out 2019, the Fed’s total assets only fell in a single week into late November. That was a modest 0.4% or $17.6b weekly drop. And damningly that very week was the only one in that entire repo-op and QE4 span where the SPX also retreated! The weekly correlation between stock-market gains and balance-sheet growth was perfect.
QE4 didn’t formally begin until 7 weeks into this balance-sheet expansion, which started with overnight and term repo ops. Between that Fed-assets secular low in late August to mid-October’s launch of actual QE4 Treasury buying, the balance sheet rocketed $206.5b higher. But the Fed’s total US Treasury holdings, which are published in another data series, only accounted for $28.0b or 13.5% of that pre-QE4 growth.
From QE4’s mid-October birth to the latest late-January data, the Fed’s balance sheet grew another $179.4b. But Treasury growth was far larger at $257.9b, 143.7% of QE4-span growth. The massive QE4 Treasury-bill monetizations are slowly displacing the repo-ops capital injections. Overall as of late January, the Fed’s assets have ballooned a crazy $386.0b higher in 21 weeks! Treasury growth was $285.9b or 74.1%.
Top Fed officials led by Powell himself have often claimed this balance-sheet expansion is not a large-scale quantitative-easing campaign. But these assertions simply aren’t credible. As of late January, the total Treasury buying since QE4’s mid-October launch again ran $257.9b over 3.2 months. That works out to $80.1b per month, way exceeding the Fed’s initial T-bill-monetization target of $60b monthly! That is huge.
This next chart zooms out to include the entire QE era starting with 2008’s first true stock panic in a century. The Fed panicked on that, slamming its federal-funds rate to zero. Of course a zero-interest-rate policy leaves no room for normal rate cuts, so the Fed simultaneously started printing money to buy bonds and euphemistically called it quantitative easing. That epic QE consisted of 3 prior major campaigns.
I’ve explained all these in depth in past essays, they’re beyond the scope of today’s. But their starts and total sizes are noted and color-coded. Balance-sheet expansions are labeled in green, neutral actions in white, and contractions in red. In actual QE and QT sizes, red numbers show US Treasuries while the yellow ones show non-Treasury QE or QT led by mortgage-backed securities. This latest QE is definitely QE4.
(Click to enlarge)
At $60b per month of Treasury monetizations, this latest QE rivals the previous massive QE3 campaign. That one started with $40b per month of MBS monetizations leading into the 2012 elections, and those were soon expanded adding another $45b per month of Treasury monetizations. So while QE4’s $60b-per-month target for Treasury buying is smaller than QE3 overall, it is the Fed’s biggest Treasury buying yet!
The big round numbers for QE and QT in this chart are total FOMC-declared targets, but the actual QE and QT per balance-sheet size varied a bit depending on bond availability for buying and selling. QE3’s final total size weighed in at $1590b in target terms, $790b of which was Treasuries. If the Fed runs QE4 into mid-Q2’20 as originally announced, the total QE4 Treasury buying at $60b per month will hit $420b.
That’s well over half the size of the expanded QE3’s total Treasury monetizations, and starts to rival the expanded QE2’s $600b of Treasury buying! So Powell and other top Fed officials claiming that QE4 isn’t large-scale QE is disingenuous at best. If it looks like QE and walks like QE, it is QE. Even mainstream Wall Street analysts have increasingly started called the Fed’s supposed not-QE as QE4 in recent months.
Despite the extraordinary SPX surge lately being perfectly correlated with the Fed’s explosive balance-sheet growth, plenty of Fed apologists still claim Fed QE doesn’t directly boost stock markets. But the SPX’s interactions with the prior 3 major QE campaigns documented in this chart strongly argues otherwise. From 2009 to 2015, the SPX trends closely mirrored what was going on with the Fed balance sheet.
The SPX surged dramatically when QE1, QE2, QE3 and their expansions were underway. But as soon as those bond-monetization campaigns ended so balance-sheet growth stopped, the SPX either corrected deeply or stalled out. QE3 is the prime example of how Fed bond monetizations are rocket fuel for stock markets. I don’t know how anyone living through that can believe QE4 isn’t hugely goosing the SPX today.
2013 was the peak-QE3 year, and biggest QE year ever. The Fed’s balance sheet skyrocketed a truly astounding 38.7% or $1,125.3b higher that year! The SPX perfectly mirrored that with a stratospheric 29.6% soaring that year, in a tight low-volatility melt-up to seemingly-endless new record highs much like this recent risky QE4 ramp. Extreme Fed capital injections directly buoy stock markets, there’s no doubt. Related: Are Cryptocurrencies Funding Terrorism?
QE3 dramatically tapered off in 2014, when the Fed’s balance sheet only grew 11.5% or $465.1b. For comparison the repo-ops and QE4 total growth since mid-August of $386.0b in just 4.8 months already rivals that! With the Fed greatly scaling back its bond monetizations in 2014, the SPX only climbed a similar 11.4% that year. The SPX’s rate of ascent in those QE3 years closely imitated the Fed’s total assets.
2015’s action sealed the deal on this inarguable correlation. With QE3 fully tapered off, the Fed’s balance sheet actually shrunk by 0.2% or $11.1b that year. The SPX followed suit, drifting 0.7% lower in 2015! It boggles the mind that anyone even tries to argue that Fed QE, or QT for that matter, doesn’t impact the stock markets in a major way. QE4’s risky SPX ramp looks much like QE3’s, and these campaigns are similar.
While QE1 and QE2 impacted stock markets too, their total sizes were pre-announced. That meant stock traders could anticipate when they were winding down. QE3 was unique in being open-ended, with the Fed only announcing monthly bond-monetization levels with no predetermined end dates. That had a far-bigger psychological impact on stock markets. QE4 is structured in this same open-ended way as QE3.
Provocatively even top Fed officials are finally starting to admit that QE4 is responsible for this amazing stock-market surge! On January 15th, Bloomberg television aired an interview with Dallas Fed president Robert Kaplan. Of course he was asked about QE4, and said it is “contributing to elevated risk-asset valuations. And I think we ought to be sensitive to that.” Fed guys know this, but don’t want to admit it.
Kaplan continued on growth in the Fed’s balance sheet, “My own view is it’s having some effect on risk assets. It’s a derivative of QE when we buy bills and we inject more liquidity, it affects risk assets. This is why I say growth in the balance sheet is not free. There is a cost to it.” That same day the Dallas Fed’s previous president Richard Fisher was interviewed on CNBC. Naturally he was asked about QE4 as well.
On the top Fed officials’ thinking on QE4 he opined, “They are seriously thinking about the effect of the expanding of the balance sheet, and its direct correlation with the S&P 500. Look at the NASDAQ, what’s happened since October. These are ferocious run-ups. ... How do you rein that in without creating a total market cave-in which could impact the real economy? I believe this is very much on their mind right now.”
QE4 can’t run forever, which is a serious problem for these record-high stock markets majorly levitated by it. The Fed’s official story on QE4 still claims it is a reserve-management thing to help restore normal repo-market functioning. By late January the Fed’s balance sheet had soared back up to $4,145.9b, up 10.3% or $386.0b from that QT-driven 5.9-year low in late August. That’s more than halfway back up to peak!
The most-bloated the Fed’s balance sheet has ever been was mid-January 2015’s $4,516.1b. That is only $370.2b away now, or just over 6 months at $60b per month of Treasury monetizations! Will the Fed allow its balance sheet to hit new record highs? Powell’s claims that QE4 is not QE would surely be widely ridiculed then. And if the Fed can’t keep ballooning its balance sheet, how does it manage to stop?
It will probably have to gradually taper off QE4 Treasury monetizations like it tapered QE3. But even that could spook stock traders, as the growing consensus is the SPX’s entire recent melt-up was fueled by the Fed’s massive QE4 liquidity injections. Fully unwinding that would require a 13.3% correction. And once stock-market selling crossed that 10% correction threshold, it could easily snowball to far-bigger losses.
QE4’s mighty stock-market rally has forced valuations to wild extremes. The SPX’s price-to-sales ratio for example surged above the previous record high seen in early 2000 at the peak of the dot-com bubble! Of course that didn’t end so well, with the SPX soon starting to fall 49.1% over the next 2.6 years in a major bear market. After Q4’18’s Fed-induced plunge, the Fed doesn’t want to be seen as triggering the next bear.
In this critical presidential-election year, politics will factor into the Fed’s decisions on QE4 too. Since 1888, fully 3/4ths of all presidential-election results are explained by US-stock-market fortunes in the final 3 months leading into the voting! I wrote a whole essay documenting this in depth in November 2016. If the stock markets are up leading into election day, the incumbent party’s presidential candidate usually wins.
If they are down in those final 3 months crucial for voter psychology, the incumbent party mostly loses. So how the SPX performs in August, September, and October this year will likely prove a major factor in whether Trump wins or loses. Will the Fed try to kill QE4 well before that to avoid tanking QE4-levitated stock markets too close to the election? If the Fed is seen as influencing its results, it will ignite a political firestorm.
Whenever the Fed decides to start tapering off QE4, whatever the reasons, it is going to prove very bearish for these extreme QE4-inflated stock markets. After QE1 ended so did its SPX ramp, with this leading stock index falling 16.0% in 2.3 months. The same thing happened during and after QE2, when the SPX nearly rolled over into a bear with a 19.4% correction in 5.2 months. QE3’s end also led to destabilization.
While the SPX first stalled out in 2015 without QE3, later that year and into early 2016 it suffered back-to-back corrections of 12.4% over 3.2 months and 13.3% over 3.3 months. But given the extremes today, a normal 10%+ correction could easily cascade into something far worse. The forced selling from passive investing strategies will be furious as stock markets decline, greatly complicating the Fed winding down QE4.
The Fed panicking in 2019 after the overdue next stock bear loomed at the end of 2018 catapulted the SPX 28.9% higher last year. QE4 was a big part of that, driving about a third of those Fed-conjured gains by year-end. These stock markets are in for a world of hurt when the Fed decides to slow and stop QE4. That will almost certainly trigger a 10%+ correction in the SPX, and could very well ultimately lead to a major bear.
These aren’t to be trifled with, as the last two saw the SPX plummet that 49.1% over 2.6 years into October 2002 and a brutal 56.8% in 1.4 years into March 2009! The Fed’s QE1, QE2, QE3, and now QE4 fueled the second-largest and first-longest stock bull in US history. The SPX has skyrocketed 392.2% over 10.9 years! Can this Fed-conjured QE-fueled monster keep running when QE4’s monetizations dry up?
The bottom line is the Fed’s QE4 Treasury-monetization campaign fueled this extraordinary recent stock-market surge. The S&P 500’s tight low-volatility ascent path since QE4’s birth in mid-October has closely mirrored the Fed’s soaring balance sheet, much like it did during QE3. But the Fed can’t inject hundreds of billions of dollars of newly-conjured money forever. Sooner or later it will have to taper off and stop QE4.
That will prove very risky for these extreme QE4-inflated stock markets. Major corrections erupted right after QE1 and QE2 ended, and QE3’s end was later followed by multiple correction-grade selloffs. The next one could really snowball given how wildly overbought and overvalued these stock markets are after the Fed’s risky QE4 ramp. The risks for a serious selloff are high as the Fed’s printing presses slow and stop.
Adam Hamilton, CPA
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