The weather on March 9, 2009 was blustery with rain, characteristic for early March in Manhattan. Few filing out of the New York Stock Exchange that evening found their workday any less dismal.
The market was off another 1 percent, continuing its downward spiral with losses over half since peaking before the financial crisis. Likely no one expected the following day would mark the beginning of the most epic surge in stock market history, a nearly 10-year-and-counting expansion with values more than tripling, uninterrupted by a single bear market with losses 20 percent or greater.
No less epic than the market’s run were extraordinary, unprecedented efforts by major central banks to provide $10 trillion of monetary stimulus to boost their economies, which most market analysts believe contributed mightily to the stock market streak.
Such central bank monetary stimulus has now ended. Since April, central banks have withdrawn more money from financial markets than has been put in, and, according to the banks, this will continue next year, primarily from the Federal Reserve.
Has the Fed’s balance sheet retrenchment contributed to the recent 9-percent stock market decline? Will market pressure continue? Can the Fed reduce the pressure?
The Fed’s initial quantitative easing monetary stimulus began in response to the financial crisis. From September to December 2008, the Fed’s assets more than doubled from $900 billion to $2.2 trillion.
Subsequent rounds of quantitative easing from October 2010 to June 2011 and again from October 2012 through December 2014 ballooned Fed assets to $4.5 trillion, five times the pre-crisis level.
The stock market and Fed balance sheet both plateaued during 2015. In the whole period after the 2008 crash through 2015, stock market indices were almost perfectly correlated with the Fed’s balance sheet.
The stock market took off in 2016 despite the Fed’s quiescence. In March 2015, the European Central Bank launched a quantitative easing program to stimulate sluggish European growth and ease the euro crisis. From its November 2014 low to today, the ECB has provided $3.0 trillion of stimulus at the current exchange rate.
As part of Prime Minister Shinzo Abe’s “Abenomics” economic program, the Bank of Japan (BOJ) accelerated its quantitative easing program in March 2013, pumping $3.4 trillion into global financial markets.
Including the major international central banks, the nearly perfect correlation between the stock market and central bank balance sheets has continued from the financial crisis to this day.
Even though the Fed only buys U.S. agency mortgage-backed and U.S. Treasury securities, financial markets equilibrate among classes of assets with varying risks and returns, so the Fed’s actions in one sector can flow throughout the markets.
Important also is that many financial markets may move in synch with the U.S. stock market. Global stock markets and equity, debt and currency markets for developing countries are often closely linked, so central bank actions have worldwide ramifications.
Looking ahead, the apparent fly in the financial markets’ ointment is the Fed’s balance sheet reduction of $50 billion per month. The ECB will cease adding assets but has no current plan to shrink. The BOJ is expected to continue growing assets around the recent pace of about $25 billion per month.
The Fed’s goal is to bring assets down from as high as 25 percent of GDP to something resembling its pre-crisis norm around 6 percent. Some economists argue the Fed should maintain a large balance sheet.
The outstanding performance of central banks with small balance sheets such as Australia, which hasn’t had a recession in nearly 30 years, and Canada, which, despite being next door to the U.S., did not experience a financial crisis, suggests financial stability is enhanced with lower central bank impact. Reserve Bank of Australia assets are 10 percent of GDP, while Bank of Canada assets are 5 percent of GDP.
So, how can the Fed reduce its balance sheet without negatively impacting financial markets? Almost all of the Fed’s actions are conducted directly or indirectly through the markets, but this is not necessary.
When the Fed buys or sells securities, it does so directly through the markets, and when it receives payoffs on existing securities, the Treasury or agency issuer goes to the financial markets for funds, so the impact remains.
An alternative is to deal directly with banks, bypassing markets. The Fed does this on a small scale with limited direct loans, but the ECB has done this on a large scale with its Long-Term Refinancing Operations (LTROs), loans to banks that will relend the proceeds. The LTROs appear to have less impact on financial markets than direct activity.
Rather than sell its holdings or wait for them to be paid off, the Fed can work with Treasury to exchange Treasury securities for excess deposits at the Fed. The U.S. government is thus exchanging one obligation, a deposit at the Fed, for another, a Treasury security with no change in overall liabilities.
The banks have government-guaranteed, liquid holdings either way with no impact on overall assets. The financial markets get a rest from large scale government refinancing, so they should have less dislocation even while balance sheet reduction can be accelerated.
As it has with other new monetary procedures, the Fed can test this exchange in a trial before full-blown refinancing. Removing the overhang of Fed balance sheet reduction can only benefit Fed operations, the financial markets and thus investors.