What’s Behind The Rally? It’s The Liquidity, Stupid.

If you’ve been bearish over the past several months, you’ve probably taken a pot shot or two (or three or four) at the Fed for characterizing balance sheet expansion as “not QE”.

Admittedly, it’s been somewhat vexing to watch stocks’ inexorable ascent, which now finds the Nasdaq 100 (for example) gunning for a fifth consecutive monthly gain, and a seventh in eight.

It’s not that anyone necessarily “wants” to see it all fall apart à la December 2018. Rather, it’s that it seems wholly unsustainable and dare we say outright unhealthy. For example, if big-cap tech manages to close January at current levels or higher, it would be the fourth straight month during which the Nasdaq 100 has gained 3.5% or more.

It’s just relentless, and eerily steady, with the precarity of the situation perhaps underscored by the action under-the-hood, where it’s clear that the reflation narrative which defined the market zeitgeist in the fourth quarter has given way to the all-too-familiar “slow-flation” trade. That’s not necessarily a “bad” thing – after all, it’s carried benchmarks to stratospheric gains in the post-crisis era. But it does suggest that the long-awaited passing of the leadership baton to sectors and styles associated with an earnest acceleration in global growth has been delayed yet again.

If you’re one of the many who’s vexed by this, you’ve probably found yourself pointing to the Fed’s balance sheet expansion to help explain away both the Q4 surge and the gains in the new year. “It is QE”, you’ll say.

But really, it’s not. It will be, before it’s over, as it seems likely that the Fed will eventually feel compelled to buy coupons, but for right now, “reserve management” is a better description of the Fed’s action than “QE”. After all, the overarching goal is to get back to an abundant reserves regime with a buffer, not to compress risk premia and drive investors out the risk curve and down the quality ladder.

But even if it’s not QE, it is liquidity, and that’s bullish, and also frustrating for anyone convinced that things “shouldn’t” be going like they’re going for equities.

“As the Fed has expanded the size of its balance sheet, we have been of the view that the resultant excess liquidity has been beneficial for stock prices and multiples”, Morgan Stanley wrote this week, adding that “the potential impact of the Fed on equities has been a central feature of almost all our client conversations”.

Morgan’s clients, like everyone else, “suspect” there’s a link between Fed balance sheet expansion and equities’ recent gains but, as ever, that effect is difficult to quantify and otherwise “hard to pin down”. To be sure, the recent expansion sticks out (see top pane).

In an effort to get a better read on things, Morgan took a look at average monthly total returns for the S&P in non-recession months when the Fed expanded the balance sheets and in the subsequent months. They also broke things down by “periods of acceleration” and “deceleration”, where that just means whether the balance sheet grew more than it did in the prior month and vice versa (i.e., it grew, but less than the previous month).

“When the balance sheet expanded, the S&P returned 128bps and another 166bps in the following month”, the bank writes, summarizing, and adding that while “the higher average returns are encouraging, monthly returns on the S&P are fairly volatile and exogenous fundamental forces can overwhelm liquidity dynamics so difference tests for statistical significance generally fail to corroborate a definitive difference in returns”.

(Morgan Stanley)

Amusingly, then, this is a case where there’s something going on, and everyone can put their finger on it, but attempts to quantify it and ascribe causation generally fail. This has been a persistent feature of analysis looking at the link between QE and stocks.

Of course, nobody doubts that accommodative monetary policy is in large part responsible for supporting risk assets. Indeed, nobody seriously questions whether stocks’ post-crisis explosion is at least partially down to rate cuts and QE.

11 years on from the GFC, there is almost no one left who will contend that central banks haven’t been a critical part of the equation when it comes to pushing equities to ever higher highs. If anything, you’ll get a straw man argument along these lines: “But other factors played an important role, too!” That’s correct. And nobody said other factors weren’t involved. Hence the straw man characterization.

The Fed’s new repo schedule (released on Tuesday), shows a desire to taper the amount on offer in term operations, but the pace of bill purchases remained steady at $60 billion. The whole idea is to soak up the repos with bill buying, and then taper that too.

And yet, as we’ve seen over the past decade, it’s difficult (if not impossible) to wean markets off low rates and the liquidity drip.

Describing the chart below, Morgan Stanley notes that “the purple, green and yellow lines show the potential evolution of the MoM changes in the Fed’s balance sheet based on the 25th percentile, median and 75th percentile of responses to [the Fed’s December survey of market participants], with an embedded assumption from us that the take down rate on available repo facilities is 60%”.

(Morgan Stanley)

The bottom line is that “in most scenarios the balance sheet will continue to expand through the first half of the year”, the bank remarks.

Let’s face it, it’s probably going to keep expanding in perpetuity, at least from a “trend” perspective.

Discussing the Fed’s recent actions, including rate cuts, the notion that the bar for the resumption of hikes is very high and the T-bill purchases on Wednesday, the Dallas Fed’s Robert Kaplan told Bloomberg’s Michael McKee that “all three of those actions are contributing to elevated risk-asset valuations”.

“And I think we ought to be sensitive to that”, he added.