The Federal Reserve continues with its hawkish tone as it decided to increase the fund rate to 1.5% in the Federal Open Market Committee’s December meeting. Most of the board members think the outlook for inflation will remain stable in the medium term. The rate hike came as the Fed observed consistent improvements in labor markets along with solid growth in the economy.
However, this is the second rate hike in the second half of the year despite the fact inflation remains subdued. According to a press release:
“On a 12-month basis, both overall inflation and inflation for items other than food and energy have declined this year and are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.”
Putting aside the ineffectiveness of the Fed’s policies to steer inflation, interest rate hikes and signaling of balance sheet normalization are not distressing the U.S. stock market yet. This is a concern as most of the commentators rationalize the current market being in a bull phase due to the Fed’s expansionary monetary policies. If the Fed’s easing monetary policy did not cause the extended bull market, then what did?
Monetary easing does not equal money printing
Before going into detail, it should be clarified that quantitative easing did not involve printing more money. The Federal Reserve’s large-scale asset purchasing, also known as quantitative easing, merely increased reserves of banks involved in brokering the purchase of assets. Banks are only allowed to use those reserves in interbank transactions. The point is the rise in stock markets cannot be explained by excessive money printing because there was not any.
Is monetary easing really boosting stock markets?
Some critics who want to debunk the role of quantitative easing in the recent bull market cite earnings as the reason for the current environment. But the argument is weak given the fact price-earnings (P/E) ratios are trading higher than their historical averages. If excess money supply is not boosting P/E, then stocks are overvalued by P/E standards. On the other hand, proponents of the idea of quantitative easing’s role in stock market growth are having a hard time explaining the current run in stocks as the Fed already called for balance sheet normalization and rate hikes.
Easing and the stock market – some theories
Despite the indifference of the stock market to the Fed’s announcements, the positive effect of easing on stocks is compelling as far as the theory goes. The buying of assets by the Federal Reserve makes the said assets scarce, leading to increased prices and lower yields. Thanks to the trend in passive investing, declining yields force investors to rebalance their portfolios in favor of risky assets. This is how the Fed's easing policy increases prices of assets in the stock market. This is not the only channel though. Through asset purchases, the Fed also effectively increases the deposits of non-banking financial institutions who are party to such asset purchases. The availability of additional deposits increases the risk-appetite of those non-banking financial institutions, and they indulge in buying alternative assets, including stocks. This also explains the rise of stock markets. However, all this is theory. There is no solid empirical evidence that explains the rise of stock markets through quantitative easing.
Is the link between monetary easing and stock markets broken?
Rising rates and balance sheet normalization are also not doing the trick. On the surface, it appears the link between the stock market's rise and quantitative easing might be broken. However, there are many things to consider before jumping to such a conclusion.
Threshold fund rate might explain the disconnect
For starters, interest rates are relatively low in absolute terms despite the recent increases. The fund rate of 1.5% to 2% is not enough for investors to rebalance their portfolios in favor of fixed-income assets, and stock prices stay inflated. However, there will be a threshold interest rate, so portfolio rebalancing will impact stock markets negatively above that threshold. What is the threshold? Well, that is the million-dollar question.
Immaterial normalization can be another reason for disconnect
Balance sheet normalization is not affecting the stock market for two reasons. First, there is a lag between the reduction of balance sheet and transmission of the policy to the market. Once the Fed sells the securities, it will take time for investors to balance their portfolio. Secondly, and more importantly, the normalization is minuscule for now. The initial cap for reduction stands at $6 billion. This is not material when compared to approximately $4.5 trillion of total assets and approximately $2.3 trillion of reserve balances. Once the cap increases and the Fed starts selling a material amount of assets, the stock markets will feel the effect.
”‹Passive investing might be shielding the stock market
Another important point is the rise of passive investing. Due to an extended bull market, passive investing is on the rise. Low-cost exchange-traded funds (ETFs) are the way to go as it has been difficult to beat these funds in the recent bull market. In 2016, cash outflow from active funds amounted to $304 billion while passive investing ingested more than $500 billion in cash inflows. The point is rising markets increase investors’ confidence, leading to further passive investments. As passive investors do not care about asset selection, the stock markets rise despite poor performance. This phenomenon might be at play here, and the market is ignoring the negative stock market signals from the Federal Reserve. This also highlights investors’ tendency to buy high and sell low, rather than the other way around.
Final thoughts
There are no signs of a slowdown in the U.S. stock market despite rising rates and the Fed’s plans to reduce balance sheet assets. The theoretical link between monetary policy and the rise of the stock market is quite strong. Therefore, the Federal Reserve should not be ignored as a material decline in the balance sheet and rates rising above the threshold would negatively impact the stock market. The bottom line is it would not be wise to become complacent with rate increases and balance sheet normalization.
