The Shrinking Fed Balance Sheet and the Rising Stock Market.

Older investors like myself, who have been through the Great Financial Crisis (GFC), have seen how the US Federal Reserve pumped in a huge sum of money to prop up the financial system.

There is this narrative that pumping in so much money would immediately cause inflation problems, but for about ten years, we did not see the CPI tick up. You cannot fault someone for thinking that way, but then how many of us really understand how financial markets work?

Inflation didn’t happen because most of the money ended up on the balance sheet of the Federal Reserve and the banks and not so much out in circulation. But the money to save us during Covid is different in that some of the money end up directly going to the people. Therefore we have inflation issues.

Sherwood News has two pretty interesting charts which show the money tightening extent we seen these few years:

Why this boost stock prices:

1. Fed balance sheet goes up because the Central Bank buys Treasury bonds or government-guaranteed mortgage bonds.
2. Private investors have more money.
3. The investors seek higher returns for their money and so seek out riskier investments such as stocks.

But according to this chart, the balance sheet is actually shrinking!

The Fed is letting the bonds mature and not borrowing new ones.

Many of us find this hard to believe but the chart actually show there were periods where their balance sheet is not rising, decelerating and now going down. It is a wonder if we can go back to 4 trillion which is before the Covid Crisis.

The big worry is what are the repurcussion.

Some of us would see frequently a chart of the money supply versus the stock market. Without the liquidity, could the stock market keep going up?

Well… we can see the relationship now deviating now.

One of these is wrong is the simplistic answer. Either the market will come crashing down or… the relationship is not always if A happens then B will surely follow.

And now that we are on the potential start of Fed Easing, what would happen? Perhaps the opposite surprising effect will happen. The market will have more liquidity and then the stock market will plunge.

But what will be the reason?

I am not sure. But usually the reason will only appear in hindsight after either we make or lost enough money.

---

If you want to trade these stocks I mentioned, you can open an account with Interactive Brokers. Interactive Brokers is the leading low-cost and efficient broker I use and trust to invest & trade my holdings in Singapore, the United States, London Stock Exchange and Hong Kong Stock Exchange. They allow you to trade stocks, ETFs, options, futures, forex, bonds and funds worldwide from a single integrated account.

You can read more about my thoughts about Interactive Brokers in this Interactive Brokers Deep Dive Series, starting with how to create & fund your Interactive Brokers account easily.