How The Fed Put Has Affected Risk Assets
The US Federal Reserve (Fed) asset purchases significantly affect the value of risk assets (equity, commodity, real estate, etc.). We recently completed an extensive research project to learn more about this effect and how we might use this information to better trade the financial markets. We reviewed Fed statements, minutes, discussions, and any published information we could find. We also evaluated weekly changes to the Fed’s balance sheet going back to 2003. In this article, I am going to share with you our findings.
On January 1, 2008, the Fed balance sheet was $470 billion. For the sake of this article, assets are considered US treasuries and mortgage-backed securities (MBS). Today, its balance sheet is just shy of $9 trillion. The Fed stopped purchasing assets in March of 2022 and will start reducing its balance sheet in June 2022. What does this mean for risk assets in the future?
When the Fed is purchasing assets, they have their foot on the gas. The seller receives cash for their asset(s), adding liquidity to the financial system. The Fed hopes that this cash will increase economic spending. The process of the Fed adding liquidity to the market is commonly known as Quantitative Easing. When the Fed sells assets, it is called Quantitative Tightening. When they normalize their balance sheet, they let the bonds on their balance sheet mature and don’t replace them with new bonds, thus shrinking the size of their balance sheet.
Based on our research, the only thing that seems to matter is whether the Fed is purchasing assets – “gas on.” If they have their foot on the gas, risk assets get a bid. On the other hand, if they stop purchasing assets, start selling assets, or normalize their balance sheet, volatility spikes and risk assets decline in value – “gas off.”
When the Fed purchases assets, it is usually a knee-jerk reaction to the markets. Think March 2020. When they stop buying assets, the Fed normally gives the markets at least two months’ notice but sometimes longer. On December 28, 2021, we were told that the Fed would stop purchasing assets in March 2022. Since then, what has happened is what typically happens each time the Fed gives such a warning. In other words, you don’t need to wait until the Fed officially stops purchasing assets to pare down your risk exposure. Volatility generally spikes shortly after the announcement.
Now the bad news. Other than cash, there has historically been no place to hide. Since 2008, when the Fed took its foot off the gas, most risk assets did poorly. Some may go flat but most drop like a safe. It may be different this time around for commodities, but historically, this wasn’t the case. Below in Table 1 is a side-by-side comparison of risk asset performance during “gas on” vs. “gas off” environments.
The Fed officially begins reducing its balance sheet in June 2022. The official plan is in Table 2 below:
Unlike the US Treasury, the Fed cannot give money directly to citizens. However, they have figured out a workaround to this limitation by purchasing MBS.
- The Fed has learned that buying MBS lowers mortgage interest rates.
- Lower mortgage interest rates cause real estate prices to increase.
- When real estate values increase, people take second mortgages and pull cash out of their overvalued real estate.
- Consumers flush with cash spend money, causing risk assets to appreciate.
The Fed did the right thing by purchasing MBS in 2009 because the market suffered from a lack of liquidity. There was no reason to do so in 2020. Since the bottom of the COVID era, they have purchased $1.5 trillion in MBS. Real estate is a very levered trade, so the MBS stimulated wealth effect is primarily caused by levered money. If real estate declines, it can get ugly fast.
We cannot find a time when the Fed sold assets into the secondary market. They may have done small amounts in the past, but it rarely happens. At their purchase peak in 2020, the Fed became one-third of the market for MBS. Transitioning from a dominant liquidity provider to a net seller could cause mass pandemonium. Their preferred method is to normalize their balance sheet by letting assets mature over time, but it may not have that luxury. The Fed’s goal in September and beyond is to reduce their MBS by 35 billion a month. Because MBS has a long duration and fewer people will be refinancing their mortgages due to higher interest rates, the Fed may have to sell MBS into the secondary market to hit its 35-billion-dollar goal.
Since 2008, the market has become addicted to Fed stimulation. Over the last 14 years, the Fed has conducted four quantitative easing programs. Be careful with your decisions moving forward because you are likely making your decisions based on a market environment that the Fed has heavily manipulated. Breaking the addiction will be difficult, but hopefully, inflation will force the Fed’s hand to stop manipulating financial markets via asset purchases. Everyone is a capitalist in a bull market but quickly becomes a socialist during bear markets – this has to change!
Spiraling inflation will likely cause the “Fed Put” to go away. Based on what we have learned, there is significantly more downside risk than normal. At a minimum, expect high levels of volatility as the market attempts to find an equilibrium. There have been 26 bear markets since 1929, with an average decline of -35.62%. Based on this average, the S&P 500 would bottom at (4,804.06 x 64.38% = 3,093). If the Fed continues with its stated interest rate increase and balance sheet reduction plan, you should expect this bear market to be worse than normal. Have we been here before? It strangely feels like May of 2008. Good trading!