- Fed’s massive balance sheet expansion appears to be helping stocks
- FOMC today expected to stress that aggressive stimulus will continue
- U.S. core CPI expected to edge lower to +1.3% y/y
Fed’s massive balance sheet expansion appears to be helping stocks — The Fed since March has engaged in a massive buildup of its balance sheet by buying Treasury, MBS, and corporate bond ETF securities, and also by lending out cash to a wide variety of different entities and markets. The Fed’s balance sheet has soared by $3.0 trillion (+72%) since the end of February to a record of $7.2 trillion. The Fed’s balance sheet has soared to 33% of U.S. GDP from 19% before the pandemic.
The Fed in just the last three months has boosted its balance sheet by $3.0 trillion, which is far more than the QE3 program of $1.7 trillion that took about two years to complete. In fact, the Fed is currently on pace to exceed the combined value of $3.725 trillion of the QE1 ($1.425 trillion), QE2 ($600 billion), and QE3 ($1.7 trillion) programs, which took six years to complete (from Nov 2008 through Oct 2014).
The speed of the Fed’s balance sheet expansion is unprecedented, meaning there is no real historical guidance as to the impact of the Fed’s QE move. The Fed’s liquidity is greasing the wheels of the financial system and is preventing systemic financial problems from developing. Some of that liquidity also seems to be finding its way into the stock and bond markets, thus boosting asset prices, household wealth, and business confidence.
The nearby chart suggests that the Fed’s balance sheet expansion has played a part in boosting the stock market. There was a fairly strong correlation between the rise in the Fed’s balance sheet and the stock market from 2009 through 2014. However, the stock market was then able to keep rising during 2016-2020 even when the Fed’s balance sheet was moving sideways to lower, suggesting that the Fed’s balance expansion had done its job in launching the stock market into its own orbit. The Fed’s current balance sheet surge also seems to have given a strong boost to stocks.
FOMC today expected to stress that aggressive stimulus will continue — The FOMC at its 2-day meeting that ends today is expected to leave its main policy variables unchanged. The FOMC is expected to stress that there are still major downside risks and that it needs to continue with its aggressive stimulus measures. Those stimulus measures include (1) the cut in the funds rate target by -150 bp to 0.00%/0.25%, (2) nine different lending programs that are funneling liquidity directly to specific markets and sectors, and (3) the Fed’s unlimited QE program.
The U.S. economy remains in very rough shape with a net plunge of 19.6 million payroll jobs. The FOMC has so far managed to prevent a systemic financial crisis, but there are still many risks in the muni, mortgage, and corporate bond markets, and it is far too early to assume that the coast is clear.
The main news out of today’s meeting will be the Fed’s new set of macroeconomic forecasts, which were suspended during the pandemic crisis. The Fed has not released macroeconomic forecasts since December.
The market is expecting the FOMC to leave its current fed funds target range of 0.00%/0.25% in place until at least 2023. The federal funds futures curve indicates that the market is expecting a slight 3-4 bp dip in the effective federal funds rate from the current level of 0.07% to the 0.03-0.4% level in the latter part of 2021. The market is then expecting a slight rise in the funds rate to the 0.11% level starting in mid-2022. Even after that expected rise, the funds rate would still be below the 0.125% mid-point of the current funds rate target range of 0.00%/0.25%.
The Fed has convinced the markets for the time being that it will not adopt a negative funds rate target. Federal funds rate futures for 2021 were trading at -0.03% several weeks ago. However, the Fed then started a concerted PR campaign whereby nearly every Fed official that spoke publicly stated that the Fed was not considering negative rates. That PR campaign caused the 2021 fed funds curve to rise back above zero to its current level of 0.03%/0.04%.
The Fed’s view is that it does not believe negative interest rates have been effective overseas in Europe or Japan. The Fed also believes that negative rates would hurt bank profitability and individual savers. The Fed isn’t mentioning the obvious concern that negative interest rates could spark a run on America’s $2.5 trillion of money market funds and potentially cause a systemic financial crisis.
The FOMC this week is expected to start a discussion on the possibility of adopting a yield-curve control policy where it pegs the 2-year or 5-year T-note yield at a certain yield level as a means of maintaining an upward sloping yield curve, while also preventing longer-term yields from rising and hurting the economy. However, no decision on a yield-curve strategy is expected to be announced this week.
U.S. core CPI expected to edge lower to +1.3% y/y — The consensus is for today’s May CPI report to be unchanged at +0.3% y/y and for the core CPI to edge lower to +1.3% y/y from April’s +1.4%. The headline CPI was undercut by the plunge in oil prices in April, but oil prices during May steadily recovered. The core CPI is expected to edge lower in May since the pandemic-induced plunge in the economy caused a huge amount of slack in the economy and put downward pressure on the prices of goods and services.
The markets are expecting soft inflation figures to continue in coming months, giving the Fed an additional pretext for continuing its extraordinarily easy monetary policy. The 10-year breakeven inflation expectations rate is currently at 1.24%, which is far below the Fed’s +2.0% inflation target. The market is signaling that it believes it could take years for the Fed to get inflation back up to its 2.0% target.
