English

The Fed Can’t Buy an Eternal Bull Market

With its 8 trillion $ balance sheet, the Fed created the equivalent of the net worth of 72 Warren Buffetts. But it is getting clear that downsizing its assets will be a huge challenge, because a strong economic recovery is unlikely.

Myret Zaki
Merken
Drucken
Teilen

Deutsche Version

When it comes to stock markets, one chart, that isn’t seen that often, actually says everything: the Federal Reserve’s balance sheet curve. It tells us that markets are sitting on the lap of a major buyer of Treasuries and mortgage debt, that provided a floor for financial markets for the last 12 years. Total assets reached 7800 bn $ as of April 27, 2021, after the Fed bought assets for 3200 bn $ from 2019 to 2020, stoking the current investor euphoria.

To get an idea of how heavily the Fed assets beef up the markets: they represent 40% of the whole market value of Treasury debt. And they are equivalent to 25% of the S&P 500’s market cap (the sum of all the market values of the individual stocks in the index). The Fed balance sheet is almost double the GDP of the UK. It represents the equivalent of the net worth of 72 Warren Buffets instructing their wealth managers to allocate all their wealth to US bonds.

Two thirds of the Fed’s 7800 bn $ are Treasuries, and the rest are mostly (residential) mortgage-backed securities. Why should this secular bond revaluation affect stock valuations? Because it is a balance sheet thing, once again. Treasury bond appreciation upgrades and supports all of the credit range. A confirmation of a good rating has always pushed the related company’s stock higher. It is a gigantic bonus to all corporate balance sheets, credit spreads, cash flows and cost of capital, a refresh button providing a new, clean face even to the junk bond categories. Even firms which only sparingly tap the credit market had their valuation favorably impacted.

A trillion here, a trillion there

Trillions are now the standard measure. For debt, that is. For gold, we’re still counting in billions: 11 bn $ in «gold certificates» now sit on the Fed's balance sheet. If we add the 8000 tons of physical gold sitting in Fort Knox, Kentucky, that is valued at 456 bn $, gold reserves are the equivalent of 6% of the Fed's assets, which is overwhelmingly made of debt.

The European Central Bank balance sheet looks similar, exceeding 7.5 tn € since February, which represents more than 70% of Eurozone GDP, while the Fed’s ratio to the US GDP is 35%. The ECB held 3.890 tn € in bonds, as of February 18, and spent almost 2 tn € on refinancing operations. An interesting observation is that ECB liquidity has largely gone into US equities, while it hasn’t benefitted the European stock market, as shown in the subdued performance of the Stoxx 600, whose performance lagged considerably behind the S&P 500 since 2009.

Going back to the Fed, its expansion dramatically benefitted US stocks because of the sophistication of the US credit market (financial credit is much more developed than in the eurozone), combined with the historical boom of tech innovation in California. The Fed became the central market player after 2008, when its balance sheet inflated fivefold over a decade, to 4500 bn $. Then, it shortly underwent a shrinking phase, between 2018 and August 2019, receding back to 3760 bn $.

This phase is worth examining carefully, because it provided a live-test as to what would happen if the balance sheet was ever to shrink again. The conclusion of the test was irrevocable: markets cannot bear any shrinkage. The «quantitative tightening» led to pressures on rates, which led to sharp selloffs in risk assets, after only a trillion in balance sheet reduction, as traders were no longer willing to borrow. Jerome Powell reverted the policy, dramatically accelerating the purchases in 2020, when more debt was bought than anytime before.

We previously analyzed in this column the consequences of having Fed-centric markets and central bank liquidity : it considerably increases the correlation between all assets, as selectivity drops. At the moment, stocks, bonds and cryptocurrencies are all at a high level. Brief corrections happen, but the overall trend is uniform. The other consequence we point out is the considerable challenge the Fed faces: namely the impossibility to scale back its balance sheet. As it is reaching almost 8 tn $, the possibility to get back to even 7 tn $ looks perilous, unless strong growth is confirmed, especially on the job front.

According to the Pew Research Center, a full recovery for the labor market appears distant and some Covid effects might have been underestimated. «The decrease in labor force participation suggests that the official unemployment rate understates the share of Americans who are out of work», says the paper. Therefore, Fed chair Jerome Powell suggested that those who left the labor force since February 2020 «should be counted among the unemployed to gain a better understanding of the slump in the labor market».

One issue that the Fed balance sheet cannot solve is the labor market slump. It is time, therefore, to break from the over-reliance on monetary policy, and revert back to fiscal policy.

Myret Zaki

Myret Zaki started in 1997 as a junior analyst in a Geneva private bank where she learnt the basics of equity research, before joining the daily newspaper «Le Temps» in 2001, where she was in charge of the finance section for 9 years. When the financial crisis broke in 2008, she wrote the investigative book «UBS, am Rande des Abgrunds» (originally published in French as «UBS, les dessous d'un scandale»), for which she received the Schweizer Journalist prize. She joined «Bilan» magazine in 2010 where she became Chief Editor from 2014 to 2019. Between 2010 and 2016, she wrote three other bestselling books, about Swiss banking secrecy, the end of the Dollar reserve status, and the rise of the shadow banking system. She has a Political Science Bachelor from the American University in Cairo and an MBA from the Business School of Lausanne. She is now head of the Communication faculty at the School of Journalism and Media in Lausanne.
Myret Zaki started in 1997 as a junior analyst in a Geneva private bank where she learnt the basics of equity research, before joining the daily newspaper «Le Temps» in 2001, where she was in charge of the finance section for 9 years. When the financial crisis broke in 2008, she wrote the investigative book «UBS, am Rande des Abgrunds» (originally published in French as «UBS, les dessous d'un scandale»), for which she received the Schweizer Journalist prize. She joined «Bilan» magazine in 2010 where she became Chief Editor from 2014 to 2019. Between 2010 and 2016, she wrote three other bestselling books, about Swiss banking secrecy, the end of the Dollar reserve status, and the rise of the shadow banking system. She has a Political Science Bachelor from the American University in Cairo and an MBA from the Business School of Lausanne. She is now head of the Communication faculty at the School of Journalism and Media in Lausanne.