To underscore my point that the rules of the game have changed and that we are now in uncharted waters when it comes to the Fed and the stock market, I think it might help to illustrate just how important the Fed’s accommodative monetary policy is for the stock market.
There have been 6 stretches of time since 2008 when the Fed balance sheet was expanding due to QE. What I want to do here is determine exactly how much the stock market went up during those periods of QE, and how much it advanced when QE was on hiatus.
Using Yardeni Research‘s timeline of Fed easing as well as data on the Fed’s balance sheet, let’s try to reconstruct the past 13 years of market history and figure out how much of a difference the Fed has made in this long bull market:
- November 25, 2008 – March 31, 2010: +38.1%. The Fed announced QE1 in the depths of the Global Financial Crisis, after the stock market had already fallen 46% from its 2007 peak. After a brief market rally, stock prices headed to new lows but then bottomed out for good on March 9, 2009 and began heading higher, encouraged by a report that Citigroup, one of the beleaguered Big Banks, had turned a profit for the first time since 2007. The official end of QE 1 was March 31, 2010, and the Fed altogether purchased $1.5 trillion in bonds. From the announcement of QE1 on November 25, 2008 to its official termination on March 31, 2010, the market rallied 38.1%.
- It’s also important to note that on March 16, 2009, the Fed announced it was significantly expanding QE1 by $750 billion, up to $1.25 trillion. This really boosted the market turnaround, and from this point to the end of QE1 in 2010 the market was up 56%.
- March 31, 2010 – August 27, 2010: -11.4%. Shortly after the end of QE1, markets enter a fairly nasty multi-month correction until mid-late August, when the Fed begins making noise about easing resuming accommodative policy.
- August 2010: On August 10, 2010, the Fed announces that it will initiate QE1 rollover, meaning it would be maintaining its balance sheet rather than unwinding it. Markets continue falling for a couple of weeks, but then the Fed hints at QE2 on August 27, and stocks immediately shoot higher.
- November 3, 2010: QE2 is officially announced. Markets had been rallying since the hint at QE2 in late August and continue to run higher after the Fed announces QE2 and the $600 billion in Treasury purchases it will entail. From early November 2010 until early July 2011, the Fed balance sheet increases by $600 billion, but then levels off. The market has increased by 29% over this period, but with the Fed balance sheet no longer growing, and a budget standoff between the Republican Congress and President Obama that resulted in America’s credit rating being downgraded, markets crash lower. Between July 25 and October 4, 2011, the S&P 500 falls by about 20%.
- September 21, 2011: Fed announces Operation Twist, a stimulative program in which it will buy long-term bonds and sell short-term bonds. OT is a less aggressive form of stimulus as it doesn’t expand the Fed’s balance sheet on net, but its objective was to lower long-term interest rates given that it could not reduce short-term interest rates any further as they were already at zero. In the Fed’s words, “This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative.” The Fed statement indicated the program would finish up around the end of June 2012. From the start of Operation Twist on September 21, 2011, until May 1, 2012, the market rallied 21.4%.
- The market enters a 10% correction in early May 2012 due to fears over slowing economic growth and the eurozone debt crisis.
- June 20, 2012: Fed announces extension of Operation Twist, and a week later announces QE2 is officially over. The market rallies a bit but sells off starting in October 2012. The Fed had announced QE3 on September 13, 2012, however the balance sheet expansion didn’t officially begin until January 2, 2013. Operation Twist is terminated on December 31, 2012.
- Between January 2 and June 13, 2013, the market rallies 17.5%. On June 13, Bernanke begins discussing the idea of tapering the QE program, and the market has a brief, mild pullback. The bond market goes crazy in what was known as the “Taper Tantrum,” but stocks continue their rise for all of 2013 and into 2014. Bernanke announces the Fed’s plan to begin tapering bond purchases on December 18, 2013, but the market continues rallying until September 14, 2014, when the Fed announces its plan to normalize monetary policy. The market sells off sharply but then rebounds quickly. Between January 2, 2013, and September 14, 2014, the market is up 44%.
- October 29, 2014: QE3 is officially terminated, but the Fed says it will maintain its balance sheet at existing levels in order to maintain accommodative financial conditions. With the Fed no longer easing, stocks essentially plateau. There are two sharp corrections in 2015, but the market has only gone up 7.5% in the two years since the termination of QE3. Yellen, now in charge of the Fed, also announces a 50 basis-point interest rate hike in late 2015, the first-rate hike since mid-2006, and this plays a role in keeping markets spooked, but the Fed won’t hike again until late 2016.
- November 7, 2016: Donald Trump is elected President and the market, after freaking out on Election Night, begins exploding higher on the hopes that Trump will be pro-business and a boon for the economy. The market, in large part due to Trump’s tax cuts, goes up 37% from the time of Trump’s election until February 2018, and the Fed has been hiking rates the whole time, although rates are only at 1.5% by January 2018. In June 2017, the Fed announced it would be normalizing its balance sheet starting in October, although the balance sheet doesn’t begin shrinking until early 2018, which is why the market has a sharp correction right around that time.
- 2018: Markets consolidate after the sharp selloff in February, but grind higher for the next several months, peaking out in October. Interest rates are about 2.5% by this point, but the market thinks they’re too high and gets jittery. The deep correction that begins in October 2018 is sparked by the “Trump trade war” narrative, re: China. Markets are down about 20% before Powell starts adopting a more dovish tone, and markets begin rallying in January 2019.
- With fears of a looming recession hanging over the market in 2019, Powell becomes increasingly more dovish. The Fed cuts interest rates twice in the second half of 2019, and on October 11, 2019, Powell announces that the Fed will again begin purchasing bonds and expanding the balance Fed’s balance sheet. The markets, which by October 2019 had essentially gone nowhere since February 2018, explode higher on the news of rate cuts and Fed easing for the first time since 2014. Fed critics refer to this as Powell’s “Stealth QE.”
- Markets rip higher by 18% from early October 2019 to February 2020, but then the Covid pandemic and the lockdowns hit, sending markets into a full-blown collapse, and by March 23, 2020, the S&P 500 is down 35%.
- In response to Covid and the lockdowns, the Fed immediately cuts rates to zero and begins a massive round of QE, and both polices remain in place today. The market has more than doubled since the bottom of the Covid Crash, and that’s how we got here.
It’s a lot easier to understand the Fed’s true impact on the market if we visualize it. Let’s go in sections so we can really get a close look. We’ll start with late 2008-2012, which entails QE1, QE2 and Operation Twist.
I don’t know how to make the images bigger, it’s very annoying. It’s probably blurry and hard to read, but essentially what we have here on this chart is that between the expansion of QE1 and the end of QE1–from March 16, 2009 to March 31, 2009–the S&P went up 55.4%. After QE1 ended, it was down 10.7%. It only started going up once the Fed hinted at QE2, and from that point on, the Index was up 28% until the balance sheet expansion ceased in early July 2011. From there, the market went down over 15%, and then reversed to turn higher when the Fed announced Operation Twist in September, 2011.
In other words, when the Fed was easing or staking proactive measure to stimulate the economy, the market was going up. When the Fed wasn’t boosting the markets, markets did poorly.
Let’s move on to the next several years on the chart, 2012-2016:
We can see that when the Fed announces Operation Twist in 2011, the market immediately begins rallying. It’s interrupted by a brief correction in response to the Eurozone debt crisis, but the Fed then announces it’s expanding Operation Twist on June 20, 2012. Operation Twist ends on December 31, 2012. The market has advanced by 28% during Operation Twist altogether.
QE3 begins January 3, 2013, and the market rips higher for the next 20 months basically, until the Fed announces the taper is complete on September 14, 2014.
From there the market goes sideways with a few scary corrections in the second half of 2015. There’s also a rate hike in November 2015 that spooks markets.
Essentially from the end of QE3 in September 2014 to the time Trump gets elected in November 2016, the market goes nowhere.
Now we’ll move on to 2017-present:
Markets explode higher on Trump optimism and the tax cuts Trump and the GOP eventually pass, but the market rally falters when the Fed begins unwinding its balance sheet in early 2018.
Markets appear to be teetering on the brink in late 2018 amid interest rate concerns and trade war fears, but Powell in early 2019 begins to take a more dovish stance. The rate hikes cease, and then in mid-2019 the Fed begins cutting rates. In October 2019, the Fed begins stealth QE.
After Covid hits, the market collapses, but the Fed comes to the rescue by cutting rates to zero and beginning a massive round of QE, and that’s where we are today.
Periods where the Fed is dovish and accommodating:
- 3/16/09 – 3/31/10: +55%
- 8/27/10 – 7/1/11: +27%
- 9/21/11 – 12/31/12: +28%
- 1/3/13 – 9/14/14: +40%
- 1/9/19 – 2/20/20: +36%
- 3/23/20 – present: +104%
Periods where the Fed was not stimulating the economy or dovish:
- 3/31/10 – 8/27/10: -10.7%
- 7/2/11 – 9/21/11: -16.4%
- 10/29/14 – 1/9/19: +23.3%
There you have it.
Basically, all of this bull market since 2009 has been because of the Fed’s accommodative monetary policy and low interest rates. Anytime the Fed would try to back off and let the markets stand on their own, markets would collapse, and the Fed would respond by either announcing more easing or some other form of monetary stimulus.
The takeaway is that you want to be invested in the market when the Fed is easing and accommodative, but not when it’s not.
Now, here’s where it gets a bit confusing.
I have demonstrated here–at least I believe I have–that beyond a shadow of a doubt, the Fed’s QE policies boost the living hell out of the stock market and may in fact be the main reason the stock market has actually gone up the past 13 years.
We can clearly see that, outside of in 2017 when the market exploded higher due to Trump/tax cut optimism, the market really only goes up when the Fed’s balance sheet is expanding–in other words, when the Fed is printing money.
But we also know that it was not until quite recently that we actually started seeing sustained inflation in the real economy.
You’d think that with trillions in printed money over the past 13 years, we would have seen rampant inflation a long time ago, right?
We didn’t. In fact, this chart from Investopedia shows that, instead of making its way into the real economy and sending inflation rates soaring, most of the money printed by the Fed during QE just wound up as excess reserves at big banks:
From the article:
The goal of this program [QE] was for banks to lend and invest those reserves in order to stimulate overall economic growth.
However, what actually happened was that banks held onto much of that money as excess reserves. At its pre-coronavirus peak, U.S. banks held $2.7 trillion in excess reserves, which was an unexpected outcome of the Federal Reserve’s quantitative easing program.
Most economists believe that the Federal Reserve’s quantitative easing program helped to rescue the U.S. (and potentially the world) economy following the 2008 financial crisis. However, the magnitude of its role in the subsequent recovery is actually impossible to quantify.
At the peak of the Fed’s pre-Covid QE in 2014, when it ceased growing its balance sheet, it had printed about $3.5 trillion starting in late 2008. And yet as we see above, in 2014, banks were holding about $2.7 trillion in excess reserves. Which would indicate that only about $800 billion of the money the Fed printed over that 6-year period could have actually been loaned out by the banks that received it.
The inflation we’re seeing now is largely a product of the fiscal stimulus that has been doled out since Covid–think stimulus checks, expanded unemployment benefits, child tax credit, etc. That’s the money that actually made its way into the pockets of average Americans, and then was in turn spent and added to the overall circulating money supply, and has caused all this inflation.
This money came from the Federal government (via deficit spending), not the Fed’s money printer.
So the question is, if the Fed has printed all this money, and the stock market shoots higher anytime the Fed is printing money, but the money doesn’t actually make its way into the real economy, then where does all the Fed’s printed money go?
Well, the logical answer would be the stock market.
And that’s true, but it turns out the printed money does not go directly into the stock market.
As this article by Tony Yiu explains, the real reason QE drives the stock market higher is that it essentially just makes bonds an unattractive investment compared to stocks:
I know the natural inclination is to scold the greedy banks for hoarding all that money. But it’s important to keep in mind that the money is not completely new money, rather it’s a replacement for the bonds that used to be held by the bank (and were bought by the Fed) — in other words, it’s swapping money in and “pseudo-money” out.
And it’s also important to keep in mind the objective of QE — for a lack of a better word, QE is designed to starve the [bond] market of yield across all durations (by reducing the supply of safe bonds) and force investors into riskier assets [like stocks], pushing up the price of those assets.
And by taking interest-bearing bonds away from banks and replacing them with reserves that earn only a minimal amount of interest, the Fed incentivizes banks to make more loans when opportunities to earn a reasonable risk adjusted return present themselves (but apparently, so far they have not).
The banks barely loan out the money they receive from the Fed during the process of QE. They mostly just sit on it and collect interest on it–it’s not a lot of interest (0.1%), but given the vast quantity of money the Fed prints and that the banks subsequently hold in reserves, it’s not actually that bad of a return especially considering it’s risk free. Wouldn’t you take 0.1% of $2.7 trillion dollars with zero risk?
The reason QE makes the stock market go up is that it makes bonds an extremely unattractive investment, pure and simple. It makes it so that investors have no choice but to plow their money into the stock market. So when the Fed is easing, it basically means bonds are a no-go because the Fed is constantly pushing their yields lower.
So yes, it’s technically correct that most of the money from QE ends up in the stock market (or the housing market, which is another asset class riskier than bonds), but it’s not directly. Technically the money the Fed prints during QE mostly just ends up as excess bank reserves and only a small portion of it actually is loaned out into the real economy.
Why? Because the Fed can’t really compel banks to loan out money if the economy is not in good shape. They would essentially be forcing banks to just hand out loans willy-nilly to people who probably shouldn’t be getting loans in the first place. It would create another subprime bubble, actually.
Just because the Fed prints out a ton of money, hands it over to banks and says, “Here, loan this out and get the economy going,” it does not mean the Fed has created compelling and sensible opportunities for those banks to lend out money in the real economy. It has only given them money to loan out. If the economy is in the dumps, it doesn’t make a ton of sense for banks to lend out money left and right. Nor are there people begging for loans.
In other words, the Fed cannot create demand for loans by increasing the supply of money available to be loaned.
All QE really does it make stocks significantly more attractive than bonds by deliberately depressing bond yields. That’s really all QE is.
Now, whether this is the Fed’s intended effect or not, it’s tough to say. Perhaps the Fed believes that by juicing up the stock market, it will be good for the banking sector, and when the banking sector is in good shape, it will spur an increase in lending and investment.
Or maybe the Fed just believes that juicing up the stock market is the best way to put money in the pockets of the American people and bolster their net worths–what’s known as the “wealth effect.” In theory it sounds good, but only if the American people are actually invested in the stock market. I don’t believe most Americans are, though. I think it’s primarily the wealthy who are in the market.
The whole thing–both QE and low interest rates–are largely a lesson in unintended consequences. And the fact that no matter how mighty and powerful you are, you really cannot force or centrally plan economic outcomes. The Fed prints money and uses it to buy bonds from banks for two important reasons: to depress bond yields (thus lowering interest rates) and to encourage banks to lend out money. But if there are no good investment opportunities out there for banks (i.e. people to loan to), then the banks will just sit on the printed money and collect risk-free interest.
Low rates, in turn were expected to compel businesses to get loans and expand, but in reality, most large businesses just took advantage of the low rates to buy back shares and boost their stock prices for the benefit of shareholders. And wealthy people take advantage of low rates to invest in real estate, and contribute to yet another housing bubble–along with the stock bubble.
The Fed, powerful as it may be, cannot create business opportunities where there are none. As crazy as it may seem given its ability to literally print money out of thin air and change interest rates at the snap of a finger, the Fed’s abilities to boost the real economy are actually quite limited (although it’s really not so crazy when you simply look at how weak economic growth has been the past 13 years even amidst the low interest rates and printed money).
I’m reminded of the old saying, “You can lead a horse to water, but you cannot make him drink it.”
The main takeaway here is that you would be an idiot to not be invested in the stock market when the Fed is easing.
But as we went over above, when the Fed isn’t easing, well it’s not such a great time to be invested.
Add in the fact that the Fed is now for the first time in 15+ years pivoting to a hawkish stance, raising interest rates in order to tame inflation–even in an economy that is now withering due to the exhaustion of the fiscal stimulus that kept it afloat the past 2 years.
It means the Fed is no longer juicing up the stock market and it’s about to deliberately tank the economy.
Not a good situation to be invested in the market. In fact in my estimation you’d be a fool to be in the market right now. You are just asking to get destroyed.
The Fed is your friend until inflation becomes a problem. Then, the Fed is no longer your friend.
I don’t think people fully appreciate how much of a game-changer inflation truly is for the Fed, and therefore the market.
For 13 years the Fed has not had to worry about inflation basically at all, so it has been free to juice up the stock market the whole time.
That is no longer the case anymore. Inflation is now the #1 priority for the Fed, and the way the Fed combats inflation is with rate hikes.
Rate hikes are going to send an already-weakening economy into recession, pop the stock market bubble (which is just about the biggest bubble in US history in terms of Shiller P/E ratio), and pop the housing bubble to boot.
Again, I think you’d be a fool to be invested in the market right now.
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