There is a negative correlation between what the S&P did a month ago and moves in the Fed’s balance sheet. In other words, if the S&P falls, we should expect the balance sheet to be increased about a month later. Once the Fed has made its change, we should expect the two to move in the same direction for the next month — a rising balance sheet raises the S&P, a shrinking balance sheet brings it down. The lag is clear; it takes about a month for a weak stock market to prod the Fed into a response, and once that response has been made the effect is felt in full a month later. 

So, the two are indeed related but with a lag. How strong is the link? The top chart shows us what we should expect the Fed to do in response to a 10% correction, while the lower chart shows the S&P 500’s response to a 10% shift in the balance sheet:

There was also — and this should surprise nobody — a marked asymmetry to the Fed’s actions. It responds to falls in the market with alacrity. It doesn’t seem to feel any great macro-prudential need to prick bubbles by comparison, and so the tendency to respond to a rise in stocks with a shrinking of the balance sheet, as seen at the end of Janet Yellen’s tenure and the beginning of Jerome Powell’s, was much weaker. In late 1996, less than two years before the “Put” era began with LTCM, Alan Greenspan was plainly worried about the possibility of asset bubbles, and uttered his famous warning of “irrational exuberance” (following through with a rise in rates that induced a minor stock market correction). Now, the idea of raising rates to curb share prices appears so outlandish to Powell that he said in June “we would never do this.”

Eoin Treacy's view

Here is a PDF of the full letter.

The Fed is reluctant to intervene to slow or reverse the rise in asset prices for a very simple reason. They believe the easiest way to objectively measure the success of their policies is in asset prices.

The continued uptrend in bond, stock and property markets is viewed as positive from the Fed’s perspective because it signals efforts to stimulate risk taking behaviour are effective. Unfortunately, that way of thinking about markets pays little heed to egregious risk taking or the assumption bad behaviour will always be bailed out.

It also ignores the fact that people who are unaccustomed and unsuited to taking risks are forced into speculative behaviour. Negative yields and close to zero interest rates rob savers of income and substitute balance sheet strength for the promise of future cash flows. The clearest evidence of that is the continued outperformance of growth over value despite a record divergence.

Railing against the system is not usually a fruitful exercise until there is some indication the situation is going to change. So far, that does not look likely. The transition from interest rate policy-based assistance to balance sheet expansion took place when interest rates approached zero. Today we have the added complication of massive fiscal stimulus.

The Fed was willing to reduce the size of the balance when the original fiscal stimulus was pushed through in 2017. That eventually choked off liquidity to first the high yield market and then the repo market. The economy was already slowing as a result of these measures ahead of 2020 and the inverted yield curve signalling a recession.

As with so many other trends, the coronavirus accelerated the pace with which the economy dropped into recession and we are now in the recovery phase because we have the classic synchronised monetary and fiscal stimulus one associates with the response to a recession.

The challenge for asset prices is the addiction to liquidity means successively larger infusions are required if the pace of the expansion is to be sustained. That virtually ensures a bubble is inflating. The time to be worried about it popping will be when inflationary pressures force the Fed to tighten but that is not an imminent prospect.