Fed actions speak louder than words.

The S&P 500 was up 18% on a total return basis in 2020 driven primarily by a 77% expansion in the Federal Reserve Balance sheet to $7.4 trillion from $4.2 trillion and nearly $4 trillion in government stimulus.  The fastest drop in history from an all-time high to down 30% for the S&P was rapidly regained and forgotten.

Simple way to think about the fed

The Federal has multiple ways to stimulate economic growth including: 1) The Federal Funds rate, 2) the purchase of assets such as bonds (Quantitative Easing) which shows up on the Federal Reserve Balance Sheet, and 3) regulation, including capital requirements like the Supplementary Leverage Ratio (SLR), on banks that lend to corporations and individuals. Simply, there is the rate you can borrow loans at, the amount of loans available to borrow, and the restrictions on how to get the loans. The reason low interest rates are a way to stimulate the economy is because it makes debt cheaper to borrow to finance spending for corporations as well as consumer purchases of goods like homes and automobiles. However, even if interest rates are low, if the Fed restricts the ability of banks to lend, while loans may have a low interest, they are harder to come by. This effectively begins to “taper” the easy money policies that have been in effect since the Global Financial Crisis and particularly since the advent of Covid.
One easy way to measure the impact of Fed policy is by looking at the supply of money in the market (M2).  If the money supply is up a lot year-over-year, then it is easy for consumers and corporations to get money.  If the supply of money starts to contract, then it gets harder. Money Supply (M2) is up 26% y/y vs a prior record of 14% set in the 1970s, and a high of 10% during the global financial crisis.

THe Recent Sell off

As I write this today (3/19), the S&P hit another record high on 3/17 (up 5.8% YTD) with stimulus checks and Fed balance sheet expansion driving it higher. Stimulus checks from the $1.9 Trillion Covid relief package reached consumers this week.  According to a Deutsche Bank survey, retail investors planned to put 37% of any forthcoming stimulus checks directly into stocks, which could represent $170 billion. In addition, the Federal Reserve Balance sheet hit a new record high of $7.7 trillion on 3/17 (up 65% y/y.)
The market sold off to end the week following the Fed meeting and their decision not to extend the SLR which to us starts the process of a stealth tapering. The SLR was an emergency move put in a year ago by the Fed that allowed banks to exclude U.S. Treasuries and reserves at the Federal Reserve from the Supplemental Leverage Ratio calculation. Simply put, this allowed banks to hold less capital and lend more money during the recession caused by Covid. The Fed, in our opinion, signaled on 3/17 that they might not extend the Supplementary Leverage Ratio (SLR) when they hiked the Reverse Repo counterparty limit from $30 billion to $80 billion. This is in sharp contrast with the comments by the Fed which were clearly meant to be very accommodative. The Fed said on 3/17, “the fundamental change in our framework is that we're not going to act preemptively based on forecast for the most part, and we're going to wait to see actual data."  However, their actions on the SLR to us were the beginning of a stealth tightening process despite what they said.
To us, the Fed actions speak louder than words, so we positioned ourselves accordingly. On 3/18, we added a large short on against our bank longs in addition to our prior shorts, including on the S&P500.  These additional shorts proved useful as on 3/19 where before the open, the Fed announced that they would not extend the SLR and financial stocks got hit. We covered the recent shorts on the S&P500 on Friday following the selloff over the prior 2 days.

Outlook on the Future

We see a rate hike coming in the future and believe the fed will have to taper their $120B in bond purchases per month before the end of the year. 4 Fed members see rate hikes possible in 2022 up from 1 in Dec. Also seven of the 18 policymakers expect see one or more rate hikes possible by 2023 up from five in December. If the Fed wants to raise rates, obviously the Fed will need to taper bond purchases first.  If they are moving up the timeline on rates going up, by implication, so is the timeline on tapering. Our belief is that the Fed is slowly trying to get the market adjusted to this tapering through their actions even if their words are different.
Stimulus has been incredibly important during this last decade for markets and when it needs to be tapered due to inflation concerns, this could be an issue as we have seen in the past.  In 2011, 2015, 2018, and 2020, the stock market fell 10-20% over 1- 5 months during periods when monetary stimulus was flat to down. 

• In 2011, the Fed hinted at not expanding its asset purchase program just before a 19% drop in the S&P 500 over 5 months.
• In 2015, talk of balance-sheet shrinkage preceded a 12% S&P decline in just a month.
• In late 2018, a comment about the Fed balance sheet un-wind on “autopilot” plus the ongoing trade war coincided with a nearly 20% S&P drop in 3 months.
• In 2020, the S&P dropped 10%, with 7% in just three trading days starting on 9/2. The Fed balance sheet had been flat to down since mid-June.

In summary, investors need to be careful as we believe the Fed is already signaling their intent to taper sooner than the market expects while continued stimulus and Covid checks may get us one last market high.