Following yesterday's [Wednesday] announcements from the Federal Reserve, it still seems likely that the Fed's balance sheet will grow to approximately $4 trillion. In previous articles I showed the correlation between growth of the Fed's balance sheet and the price action of the S&P 500 (SPY). Since 2009, the S&P 500 has rallied when the Fed purchased bonds and increased the size of its balance sheet. This correlation has held up since the start of QE Infinity in December and I expected further gains for the S&P 500 as the Fed's balance sheet reaches ~$4 trillion. However, I am revisiting this assumption because of the sell-off in the bond market. The relationship between quantitative easing [QE] and bonds is changing and may signal a change in the dynamics impacting the S&P 500. In this article I will look at the relationship between the Fed's balance sheet and the S&P 500 and the threat from the bond market.
Correlation Between S&P 500 & Federal Reserve Balance Sheet
Since 2009, the S&P 500 (red line) has moved up together with the expansion of the Fed's balance sheet (blue line).
(Source: Federal Reserve Bank of St. Louis)
Fed's Balance Sheet Going Forward
Currently, the Fed has approximately $3.4 trillion of assets on its balance sheet. Following yesterday's meeting, the Federal Open Market Committee (FOMC) announced the decision to continue purchasing $85 billion of bonds per month. However, Ben Bernanke said that the $85 billion of monthly bond purchases will likely be reduced later this year and end sometime next year:
The committee currently anticipates that it will be appropriate to moderate the monthly pace of purchases later this year, and if the subsequent data remain broadly aligned with our current expectations for the economy, we will continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year. (Source: Reuters)
If the Fed continues to buy $85 billion of bonds per month for the next four months and then reduces the amount by $10 billion per month starting in November, it will add another $660 billion to its balance sheet by June 2014. Under this scenario the Fed's balance sheet would grow to approximately $4 trillion.
Based on the correlation shown above, the expansion of the Fed's balance sheet to ~$4 trillion would suggest further upside of for the S&P 500. However, it is important to look at the impact of interest rates.
Fed's Balance Sheet & 10-Year Treasury Rates
One of the main goals of the Fed's QE programs has been to keep interest rates low. Interest rates spiked up at the beginning of QE1 and QE2, but the general trend over the last few years has been a decline in interest rates.
(Source: Federal Reserve Bank of St. Louis)
The current QE program began in December 2012. Since then, interest rates have been rising and much of the move has occurred since the May 2 low on the 10-year Treasury yield of 1.63%. Today, the yield reached 2.35%.
The price action in the bond market may suggest a reversal of the trend over the last few years (and last few decades). Bond investors were clearly not pleased with the Fed's announcements today. They responded to the news by selling bonds, which drove up yields, and the Fed's ability to keep interest rates low is now in question.
The S&P 500 has benefited from the decline in interest rates over the last few years. Low rates allowed companies to refinance debt, extend maturities and lower interest payments. Furthermore, low rates may have diverted some investment flows from bonds to stocks. If interest rates rise further, the positive impact from the Fed's balance sheet expansion may not reach the S&P 500.
The Fed's announcement yesterday indicates that its balance sheet will likely grow to ~$4 trillion. I previously believed that balance sheet growth would be a positive catalyst for the S&P 500, as it has been over the last few years, but this relationship may be breaking down. The Fed's QE programs were among the drivers of lower interest rates, but interest rates are now rising and the Fed may be losing its ability to keep them down.
I have a negative outlook on the bond market, as I described in Selling Begets Selling: 4 Bond Market Cracks Threaten Rally In Risk Assets.
A further move up in interest rates (as bond prices fall) may suppress the positive impact from the Fed's balance sheet expansion on the S&P 500. The Fed's balance sheet will continue to expand, but the S&P 500 may not respond like it used to.
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