The Powell Put: Fed Easing and Market Performance

The latest quarterly report by the Bank for International Settlements (BIS) underlines the change in the relationship between the major central banks and financial markets.  Claude Borrio, the BIS’s Chief Economist, describes the “extraordinarily tight” relationship between central banks and financial markets in the aftermath of the financial crisis and recession of 2008. Thus, the financial markets scrutinize the central banks for cues, while at the same time relying on central bank “puts” for comfort.

At the same time, central banks scrutinize financial markets for clues about the real economy.  We have seen this phenomenon illustrated first  in the May 2013 “temper tantrum”, when global financial and currency markets reacted negatively to the suggestion by then Fed Chair Ben Bernanke that the Fed would “taper down” its unprecedented Quantitative Easing (QE).

More recently, the Fed under both Janet Yellen and Jay Powell began a predictable, passive and gradual unwinding of the Fed’s balance sheet, (the so-called Quantitative Tightening, QT),  while at the same time raising the Fed Funds rate nine times between December 2015 and September 2018—with a clear path of further multi-quarters  gradual tightening towards the “neutral rate.  Initially, markets remained buoyed by strong growth in both the U.S. economy and corporate profits through most of 2018. At the same time, the Fed’s leaders where careful in avoiding any hint of a “Powell Put”. However, by the end of the year, a sharp slowdown in both the Chinese and the Eurozone economy, along with signs of an ebbing of the tax cut’s sugar high in the United States, caused the markets to switch from a risk-on to a risk-off stance, causing the main equity indices in the major advance economies to crash to multi-month lows.  With the global economy and earnings showing signs of slowing down, the equity markets were now looking at the Fed to provide support.  Powell and the Federal Open Market Committee (FOMC) obliged by doing a policy U-turn.  On December 19th, Powell hinted at a pause in what was seen as a path of steady interest rate increases, stating that we were “close” to the neutral rate.  On January 4th, the Fed chief indicated flexibility in the pace of balance sheet unwinding.  Markets responded enthusiastically, with the S&P500 gaining 20.9% in the first quarter of 2019, back to its end of third quarter 2018 level.

The Fed reemphasized its dovish message at the March 19-20 FOMC meeting, underlying its stance of increased patience in the face of what it sees as a weaker economy.  As expected, the Fed Funds rate was unchanged at 2.25-2.5%, with no increases projected for 2019.  Additionally, the Fed announced in a separate statement that is would slow down the pace of QT and bring the monthly balance sheet reduction target down from $30 billion to $15 billion. Furthermore, the Fed stated that QT would end in September.  This would bring the Fed balance sheet down to $3.8 trillion, a peak of $4.5 trillion in early 2015. 

The markets reacted in a muted fashion to the FOMC announcement, with the S&P500 gaining one per cent in the session following the announcement.  However, we should recognize that we are facing several problems.  First, the underlying message of the Fed was negative: the economy is slowing down.  This message has been underscored by the recent data, and probably reflected in the fact that the yield curve inverted on March 22---for the first time since the financial crisis of 2008.  Second, the Fed’s room for maneuver is likely to be constrained. Finally, the previous rounds of QE and zero-interest managed to yield a decade of trend growth—the economy expanded by an average of 2.6% per year over 2010-2018—and there is no reason why another round of QE and interest rate cuts would yield any better economic results.

Fig.1: Fed Balance Sheet and the S&P500

Over the past decade, the relationship between equity markets performance and the Fed’s balance sheet growth has been clear. (See Fig.1).  The statistical correlation between the size of the Fed’s balance sheet and the level of the S&P500 has been 0.84 over this period.  This is evidence that markets are hooked on Fed liquidity. However, they might need larger and larger doses in the face of a slowing economy and other negative developments in both the United States and global economies.