The Fed has pulled $2 trillion from the financial system over the last two years.

All magicians rely on misdirection, the power to focus an observer’s attention on something, while simultaneously steering that onlooker’s gaze away from something else.

In a sense, the recent will-they-won’t-they hullabaloo over the Fed’s plans to cut rates, is a masterclass in this illusionist art.

For months, as inflation has fallen, the Fed has dangled the potential for rate cuts in front of salivating investors who, well-versed in the first commandment of the stock market, see Fed rate cuts as the way to support the economy, sending corporate profits and stock prices ever higher.

And aside from the momentary early August panic, stocks have seemed to like it. The S&P 500 is up nearly 18% for the year.

Monetary mullet

At the same time, the Fed has been quietly — yet in full public view — carrying out a campaign of relentless policy tightening, via the Fed tool that dare not speak its name: the balance sheet.

It’s a reverse mullet, with the US central bank offering reasons to party out front, while carrying out some pretty serious business in the back.

The balance sheet is essentially a record of the assets, mostly Treasury bonds and government guaranteed mortgage bonds, that the Federal Reserve has bought (as well as the liabilities it owes).

TL;DR

To simplify things a bit, when the Fed’s balance sheet goes up, the central bank is often buying Treasury bonds or government-guaranteed mortgage bonds — pulling them out of the hands of private investors, who are then left with cash. The idea is that these people are likely to seek then higher returns for that money, which likely means buying riskier investments, such as stock. This so-called portfolio rebalancing channel, academics theorize, is one way the Fed’s bond-buying programs — known as quantitative easing, or QE — have tended to boost stock prices.  

The impact of such Fed purchases on the broader markets is an object of never-ending fascination for academics. But for our purposes, we can stipulate that when the Fed’s balance sheet has been going up, stocks have tended to go up too.  Sometimes, quite a bit. (Though whether that relationship is causal, or simply a correlation is a debate for another day.)

But right now, the Fed is letting its balance sheet shrink as old bonds mature and it doesn’t replace those with new purchases. Since April 2022, the balance sheet is down by almost $2 trillion.

It’s something of an understatement to say that’s a lot. There’s never been a period when the Fed’s balance sheet has shrunk this much. And if history is any guide, that might be a potential problem for stocks.

Memory Lane

For years after the financial crisis hit in 2008, any news about fresh plans for the Fed balance sheet could generate big moves in the market.

I know because I’m old, and I covered many of these boomlets and mini-panics for both the Wall Street Journal and the New York Times.

• In 2010, then-Fed Chief Ben Bernanke’s Jackson Hole hint that he could launch a second round of bond buying helped turn a miserable market mood around on a dime.

• In 2011, after the Fed paused growth in the balance sheet, the stock market started to throw a fit, demanding the Fed spring back into action again. It did, launching a new program the next year.

• As the balance sheet grew between 2011 and 2014 (when the Fed froze the size of the balance sheet again), the S&P 500 rose a remarkable 64%. With the Fed balance sheet on pause between 2014 and 2016. Stocks notched a miserly 9% gain.

Now it’s true, that there are always lots of things going on in financial markets. And the balance sheet’s predictive power isn’t perfect.

For instance, in 2017 the market surged despite little-to-no balance sheet growth and a series of sharp rate hikes from the Fed, thanks, in part, to tax cuts out of the Trump administration.

But the next year, the Fed was shrinking its bond holdings rapidly, while simultaneously raising short-term interest rates. The markets started to sell off, a downdraft that picked up pace after Fed officials suggested in December that its balance sheet would keep shrinking as if on “autopilot.”

The market hated that. The S&P 500 fell 15% in December, as President Trump began publicly threatening to fire Fed Chair Jerome Powell. The next month, the Fed backed off on its plans to keep raising rates, and started cutting rates a few months later.

Then Covid hit, and the Fed was forced to launch a brand new round of balance sheet expansion, in concert with massive fiscal stimulus, that was accompanied by another giant stock market rally.

Metaphorically speaking

The Fed’s repeated willingness to boost bond buying programs in the years after the financial crisis, steadying markets after they started to wobble, has been repeatedly likened by observers to a parent teaching a child to ride a bike.

At some point, the metaphor implies, the training wheels will have to come off, and the market will either be able to pedal forward under its own power, or it will fall.

“The next Fed chairman will have the unenviable task of removing the training wheels from markets without causing a crash.”
-The Washington Post, August 2013

"Now we're going to have to see whether investors can ride without training wheels."
-CNN Money, October 2014

The Fed, emboldened by the strong economy, has begun to take the training wheels off.
-CNN, July 2018

The Fed ‘is now tightening on all cylinders’ as the ‘training wheels' come off
-MarketWatch, September 2022

Is now that time?

With the end of 2024 coming into view, the stock market seems to be pedaling forward fine.

The S&P 500 is hovering just below all-time highs after a rapid rebound from a nasty early August sell-off.

Perhaps, investors have learned to live without the favorable tailwind the Fed’s growing balance sheet has supposedly provided for most of the last 15 years?

Maybe. But I think the lesson of the August sell-off might just be that the balance sheet still does matter a lot.

One of the more clear impacts of the academic writing about quantitative easing is that such programs seem to act as a kind of shock absorber for markets, keeping stocks from posting giant swings that can spook investors.

Now, there’s some $2 trillion less in that cushion, which perhaps explains how a relatively modest decline in the number of jobs in July, and a teensy rate hike from the Bank of Japan, sparked a serious worldwide stock market sell-off early this month, with the S&P 500 plunging nearly 10% from its July peak.

But just as suddenly, the stock market dusted itself off and bounced back, with relatively little in in the way of supportive talk from the Fed, beside indications that rate cuts it had already suggested were coming remain very much on their way.

At the risk of being overly optimistic, this strikes me as a good sign. After all, once the training wheels come off, everybody falls.

But you learn to ride when you have enough confidence to get back up and try again. Perhaps after 16 years with the Fed’s steadying hand, the market has finally reached that point, at least when rate cuts are on the way.