Fed Balance Sheet Expansion and Stock Market Performance

Oh, but her love is cold
It wouldn't hurt her if she didn't know, 'cause
When it gets too much
I need to feel your touch
--Bryan Adams

Wanted to follow up on previous comments about Fed balance sheet changes and stock market performance. I went to the Fed's website and downloaded a data package of weekly assets and capital from the consolidated Federal Reserve balance sheet (can be found in Table 8 of the weekly release, which is done each Wednesday). The data are available since December 2002.

I also grabbed corresponding weekly S&P 500 Index (SPX) data.

Fig 1 plots weekly Fed balance sheet assets and weekly SPX values across the entire time frame since late 2002. Note the slow-but-steady increase in Fed balance sheet assets (the blue series) from 2002 until late summer 2008. Balance sheet assets increased from $7.2 trillion in late 2002 to $9.3 trillion in September, 2008 (+28%). While such balance sheet expansion is not trivial, it reflects a straight line, 'non crisis' approach to inflating the money supply.

Beginning with the 9/17/08 report, the Fed began increasing balance sheet assets greater than trend. Over the course of the next six weeks, Fed assets more than doubled to over $2 trillion. That's a trillion dollars in just over a month. This was the beginning of the Fed's famed Troubled Asset Relief Program (TARP), when the Fed began buying mortgage backed securities et al off of bank balance sheets.

In case you don't know how this works, the Fed essentially gives the banks cash (generated out of thin air at the click of a mouse) in exchange for their securities. The purchased securities go onto the Fed's balance sheet as assets. Unless the Fed someday unloads all of these assets at the acquired price (highly unlikely), then what the Fed has done via these operations is inject newly minted cash into the system, which is inflationary.

You can see that since late 2008, the Fed has added another $1 trillion in assets thru its various 'quantitative easing' (QE) programs--such that its balance sheet assets now top $3 trillion.

As part of its latest asset pruchase program, affectionately labeled QE-Infinity, the Fed has pledged to buy about $90 billion/month of securities from the banks. In Ponzi-like circular fashion, the banks initially purchased many of these assets with credit created by the Fed out of thin air. At a $90 billion/month run rate, the Fed's balance sheet will be north of $4 trillion one year from now.

Fig 2 plots the same series as Fig 1, but focuses on the time period since July, 2008. You can see that the square wave increase in the Fed's balance sheet in late 2008 corresponded to the end of the decline in stock prices. The SPX marked its low in March, 2009.

Not only did Fed intervention bail out insolvent banks by lifting declining assets off their books, but the Fed also bailed out stock investors from further price declines as well.

Since then, stocks have been rising in accordance with increases in the Fed's balance sheet. Since the early March, 2009 lows, I get a correlation coefficient of .854 between Federal Reserve assets and the SPX.

Fig 2 may tell you all you need to know about why stocks have been marching upward over the past few years. Rather than being driven by fundamental improvements in the economy, there is a compelling case to be made that stocks have been floating higher on an ocean of liquidity courtesy of the Fed.

Fig 3 shows the ratio of Federal Reserve balance sheet assets to underlying capital. This is a measure of leverage. In 2007-2008, many banks that failed were levered 20-30 to 1. Currently, the Fed is levered much more than that. Current Fed leverage stands at about 55:1.

When an institution is highly levered, it takes only a small decline in the value of assets to render the institution insolvent. Indeed, John Hussman estimates that the decline in bond prices over the past few months hasalready mede the Fed technically insolvent.

No economically motivated entity would engage in such reckless behavior. The risk of catastrophic loss is too great to be borne by decision makers with their own wealth on the line.

But Fed bureaucrats are not risking their wealth. Through their recklessness, they are risking yours.

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