By Kevin Muir of “The Macro Tourist” fame; reposted here with permission
I know I have told this story before, but it bears repeating. Way back in 2011 I was watching the S&P like a hawk. Trading each squiggle, I tried to understand what was driving the markets at every point. I focused on technical levels, monitored the news and spent way too long staring at the screens.
But on some days, the stock market would get mysteriously strong. It would usually occur mid-morning. Often stocks would sag near the open, look like they wanted to break lower, when all of a sudden – out of the blue – stocks would go bid. I couldn’t understand it. There was no “reason” why they should be rising. Yet they did.
It took me a while, but eventually, I figured it out.
Although it flies directly in the face of Dr. Malkiel’s Random Walk Down Wall Street, the days when the Fed expanded their balance sheet through bond purchases resulted in outsized stock market gains. These bond buys were conducted through Permanent-Open-Market-Operations (POMO) and the great thing about a transparent Federal Reserve is that they listed the schedule in advance, so it was easy to measure the relationship between POMO operations and stock market performance.
I know it seems crazy, but the Federal Reserve’s bond buying had a direct and immediate effect on the stock market. I don’t know why the relationship would be so unequivocal, but I learned the hard way not to fight the Fed on days when they pulled out the blue tickets in the bond market. I even tracked the amount of bond buying versus the stock market outperformance to make sure it wasn’t all in my head. Sure enough, the larger the bond buys, the bigger the outperformance.
Now eventually the market figured it out and the relationship became less reliable, but that process took years.
Fast forward to today. Although the Federal Reserve has a broad schedule for winding down their balance sheet, they are not systematically selling off their portfolio. No, instead they are allowing their portfolio to mature, and at times not reinvesting the proceeds.
This means that the process is somewhat lumpy. Whereas quantitative easing purchases would be limited to $5 billion or so on any one day, with the quantitative tightening balance sheet wind-down, the maturing days can be many magnitudes larger.
Take today for example. The Federal Reserve owns the following bonds:
- $3,888,900,000 of the 9.125% of 05/15/2018
- $542,818,700 of the 1% of 05/15/2018
- $21,795,923,000 of the 3.875% of 05/15/2018
That’s over $26 billion of bonds maturing today.
I am not some lonely lunatic who singularly believes the Federal Reserve’s POMO operations directly affect the stock market.
If you don’t already follow the terrific Martingale_Macro, then give him a click. I’ll leave the math jokes aside, but will highlight that he has already observed the reverse of my quantitative easing stock market outperformance with the following table of stock market declines on quantitative tightening days:
Brilliant! I should have been on this way earlier.
The days when the Federal Reserve has a large bond maturity have seen abnormally large declines in the S&P 500. I am writing this before the close, but it’s no surprise that today’s stock market performance is weak.
I can almost hear the cries of disdain – “sure, lots of good that does bringing this to our attention after the decline.” Ahh, but here’s my value add – the Federal Reserve publishes their portfolio for everyone to see:
The next big maturity day is May 31st. On that day we get almost $29 billion maturing on month-end. Watch out below.
For those that want to play along at home, here is the link for the Federal Reserve’s portfolio. I will leave it to all the efficient market theorists to buy on those days. I’ll be pulling out the pink tickets…