John Authers' Points of No return
Comment of the Day

August 04 2020

Commentary by Eoin Treacy

John Authers' Points of No return

This edition of the former Lex Column’s editor contains some interesting charts on the correlation between Fed intervention and stock market recoveries. Here is a section:

There is a negative correlation between what the S&P did a month ago and moves in the Fed’s balance sheet. In other words, if the S&P falls, we should expect the balance sheet to be increased about a month later. Once the Fed has made its change, we should expect the two to move in the same direction for the next month — a rising balance sheet raises the S&P, a shrinking balance sheet brings it down. The lag is clear; it takes about a month for a weak stock market to prod the Fed into a response, and once that response has been made the effect is felt in full a month later. 

So, the two are indeed related but with a lag. How strong is the link? The top chart shows us what we should expect the Fed to do in response to a 10% correction, while the lower chart shows the S&P 500’s response to a 10% shift in the balance sheet:

There was also — and this should surprise nobody — a marked asymmetry to the Fed’s actions. It responds to falls in the market with alacrity. It doesn’t seem to feel any great macro-prudential need to prick bubbles by comparison, and so the tendency to respond to a rise in stocks with a shrinking of the balance sheet, as seen at the end of Janet Yellen’s tenure and the beginning of Jerome Powell’s, was much weaker. In late 1996, less than two years before the “Put” era began with LTCM, Alan Greenspan was plainly worried about the possibility of asset bubbles, and uttered his famous warning of “irrational exuberance” (following through with a rise in rates that induced a minor stock market correction). Now, the idea of raising rates to curb share prices appears so outlandish to Powell that he said in June “we would never do this.”

Eoin Treacy's view

The Fed is reluctant to intervene to slow or reverse the rise in asset prices for a very simple reason. They believe the easiest way to objectively measure the success of their policies is in asset prices.

The continued uptrend in bond, stock and property markets is viewed as positive from the Fed’s perspective because it signals efforts to stimulate risk taking behaviour are effective. Unfortunately, that way of thinking about markets pays little heed to egregious risk taking or the assumption bad behaviour will always be bailed out.

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