A Useful Leading Indicator?
We often see charts comparing the S&P 500 to the growth in the Federal Reserve’s balance sheet, or more specifically, to assets held by the Fed. There is undeniably a close correlation between the two, but it has struck us as not very useful as a “timing device”, or an early warning device if you will.
Recently we have come across a video of a presentation by Bob Murphy, in which he uses a slightly different comparison that might prove more useful in this respect. Instead of merely looking at Fed assets, he uses the total monetary base. Here is a chart comparing the monetary base to the S&P 500 Index since 2009:
The monetary base (red line) vs. the S&P 500 (blue line) – as can be seen, sometimes one or the other series leads, but in recent years the monetary base has been a leading indicator. It probably lagged the market in 2010/11 due to the fact that traders at the time bought stocks in anticipation of more monetary pumping – whereas nowadays the market appears to be reacting with a slight lag to changes in base money – click to enlarge.
Below is a chart that shows consolidated assets held by the Federal Reserve system for comparison. Since the Fed is currently reinvesting funds from MBS and treasuries that mature, its total asset base is basically flat-lining since the end of QE3. Obviously, all that can be gleaned from this fact is that the central bank is currently not actively pumping up the money supply. Currently money supply growth is therefore largely the result of commercial bank credit growth.
A Different Regime
The post 2008 monetary regime differs from the previous state of affairs due to the vast growth in central bank balance sheets and the associated growth in bank reserves. This has created a technical problem for central banks if they want to tighten monetary policy, as the Fed is planning to do.
In times past the Fed would either add or withdraw liquidity from the system by means of asset purchases, resp. sales, both of the temporary and occasionally the permanent variety (i.e., via repos and coupon passes), so as to keep the effective Fed Funds rate on target. It can no longer do this if it wants to keep the stock of assets it holds unchanged. Since selling off enough assets to return to the previous regime would collapse the money supply, it isn’t going to happen.
The Fed is primarily keeping control over the FF rate target by paying interest on bank reserves. This keeps the currently almost non-existent interbank lending market in catatonia, since there is no point in lending out excess reserves for less than one can get safely from the Fed. However, ever larger short term reverse repo operations are undertaken as well (we have previously discussed the vast surge in these transactions at year-end).
These reverse repos usually swell near month-end and especially near the end of a quarter. This seems to serve various purposes. Among these is apparently the desire to relieve collateral shortages/ delivery fails (which have increased due to QE removing a great many securities from the marketplace), but the Fed is presumably also employing these reverse repos as another way of exerting control over short term interest rates.
While the amount of assets held by the Fed doesn’t change on account of such operations (since the assets are only lent out, but continue to belong to the Fed), it seems the effect is reflected in monetary base statistics. This is illustrated by the chart below, which compares outstanding reverse repos to the monetary base. Spikes in reverse repos align quite closely with short term declines in the monetary base, even if the correlation is not perfect (as these are not the only factors influencing the base).
Demand for Stocks Declines Around Quarter-End
One thing is clear: during the brief time periods when large reverse repo operations are undertaken, liquidity in the system temporarily decreases. The lead-lag relationship between the monetary base and the S&P 500 shown in the first chart seems to suggest that this does have an impact on the stock market.
How big an influence it really represents is however not certain, as there is another important reason why the demand for stocks tends to decline around the end of the quarter. As has recently been discussed at Bloomberg, earnings season begins at the time as well, which forces companies to suspend stock buybacks for a few weeks.
Given the enormous size of buybacks in recent years (another new record high will likely be achieved this quarter), it is probably no surprise that the period during which buybacks are suspended also aligns closely with market weakness of late. Here is a chart derived from a Goldman Sachs research report illustrating this point:
According to GS analyst David Kostin, the influence of the “blackout period” is especially large at the moment, as other important groups of potential buyers are currently out of the picture:
“Corporate buybacks are the sole demand for corporate equities in this market,” David Kostin, the chief U.S. equity strategist at Goldman Sachs Group Inc., said in a Feb. 23 Bloomberg Television interview. “It’s been a very challenging market this year in terms of some of the macro rotations, concerns about China and oil, which have encouraged fund managers to reduce their exposure.”
Kostin said companies tend to enact a blackout period and restrict share repurchases in the month following the end of a calendar quarter, and come back once they’ve reported results. In a market where everyone else is selling, the ebb and flow of corporate actions have amplified volatility.”
We’re not so sure that corporate buybacks are the “sole demand for equities”, but it is probably true that buybacks or the lack thereof have more effect on short term volatility in times when other market participants are uncertain and less inclined to buy.
Regardless of which source ultimately proves more important, the above suggests that market liquidity tends to become more scarce around the end of the quarter at present. We have already seen this effect play out twice in row and it could well be that there will be another replay this quarter.
Considering what happened in 2010, much also depends on perceptions about upcoming Fed policy, but it seems unlikely that today’s FOMC statement will do much to alter expectations. We can take the buyback blackout period as a given, which leaves us with watching the monetary base for clues.
It will be interesting to see whether the next decline in the monetary base – which should be expected to occur around quarter-end based on previous observations – will once again precipitate stock market weakness. It is definitely possible that this indicator is useful for short term trading purposes – at least for the time being.
Stay tuned for a more general look at developments in the US monetary backdrop to be posted shortly.
Charts by St. Louis Federal Reserve Research, Bloomberg
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