- The Federal Reserve has been pumping billions into the financial system after the mid-September tumult in very short-term lending markets known as repo.
- As the central bank's balance sheet has expanded, the S&P 500 has grown at almost the exact pace.
- Some on Wall Street worry that the market is back to depending on the Fed's monetary juice, rather than fundamentals, as the path to gains.
Financial markets have seen this story before: The Federal Reserve rides in with piles of freshly minted digitized money that helps send the prices of stocks and other assets lurching forward.
But this isn't 2009.
Instead, it's 2019, and once again the central bank, whether by intention or coincidence, has seen its efforts to keep the financial system running smoothly end up as a bonanza for Wall Street, where the decadelong bull market has taken another leg higher in step with a Fed liquidity effort.
Since a mid-September flare-up in the repo market, where banks go for overnight financing, the Fed has been injecting billions into the markets, buying up mostly short-term Treasury bills in an effort, ostensibly, to keep its benchmark funds interest rate within its targeted range, currently at 1.5% to 1.75%.
The results: a $175 billion expansion of the Fed's balance sheet to $4.07 trillion, representing growth of 4.5% since the operations began. During that time, the S&P 500 has risen just shy of 4%.
Coincidence? Maybe. After all, the Fed has stressed repeatedly that the recent bond-buying operations are not akin to the three rounds of quantitative easing that happened during and after the financial crisis and accompanying Great Recession.
Under QE, the Fed credited primary dealers with funds in exchange for high-quality assets like Treasury debt, in an effort to loosen financial conditions, lower borrowing rates, and direct money to stocks and corporate bonds. The operations this year, as stated by the Fed, are specifically to stabilize short-term rates, though the process is identical.
Market participants see stark similarities not just in the operation — but also in its effects.
QE and the latest round of stimulus are "absolutely" similar, said Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management. "Financial conditions are extraordinarily loose and accommodative. One of the things that the Fed balance sheet liquidity has done has also been to allow the U.S. dollar to weaken for really the first time in about two years. These are things that are definitely contributing to this move in the market."
Indeed, the Goldman Sachs Financial Conditions Index, which Fed officials follow closely, is around its lows of the year, due in large part to rising stock prices and falling bond yields and credit spreads.
Shalett said the Fed's moves have also caused financial imbalances elsewhere, a key concern for central bank officials who have pushed back against the recent interest rate cuts and looser policy. She cited the since-abandoned WeWork initial public offering as one example of money looking for financial assets rather than being put back into the real economy.
"This really speaks to the idea that once again we're on the brink of potentially being in this bubble, where valuations are about the story and the narrative and not about the cash flow and profits," she said. "You would think we would have learned this lesson before. But here we go again."
Wall Street took notice earlier this week when hedge fund king Ray Dalio of Bridgewater Associates penned his latest missive for LinkedIn, this one titled "The World Has Gone Mad and the System Is Broken."
In the essay, the head of the largest hedge fund in the world noted that investors are having money "pushed on them by central banks that are buying financial assets in their futile attempts to push economic activity and inflation up. The reason that this money that is being pushed on investors isn't pushing growth and inflation much higher is that the investors who are getting it want to invest it rather than spend it."
Dalio said the active role that central banks are playing in the financial system is creating wealth disparity because the money earned by those at the top is not flowing into those further down the ladder.
"Because the 'trickle-down' process of having money at the top trickle down to workers and others by improving their earnings and creditworthiness is not working, the system of making capitalism work well for most people is broken," he wrote. "This set of circumstances is unsustainable and certainly can no longer be pushed as it has been pushed since 2008. That is why I believe that the world is approaching a big paradigm shift."
The Fed's machinations, however, are working for financial markets.
The S&P 500 has gained about 4% in the fourth quarter and more than 7% over the past three months, thanks in good part to a strong push in stock buybacks, which also have historically risen in tandem with the Fed's liquidity efforts Share repurchases are tracking 14.9% higher in the third quarter from Q2, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices.
That market gain has come even amid a more pronounced slowdown in manufacturing as well as corporate profits that appear headed for the fourth consecutive decline on a year-over-year basis. S&P 500 company earnings are tracking at a 2.7% drop in Q3 and are expected to fall 0.4% in the fourth quarter, according to FactSet estimates.
"The surge in equity markets has come on the back of the Fed hosing liquidity into the banking system via repos and T-Bill purchases," Albert Edwards, market analyst at Societe Generale, said in a note for clients. "Remember this is not QE4, as the Fed has repeatedly assured us. Tell that to the equity market, which is certainly reacting as if it was as it forges to new all-time highs."
For investors looking over the long haul, the developments should be "massively concerning," said Morgan Stanley's Shalett.
"The market is diverging from the fundamentals quite a bit," she said. "This entire cycle has been proof in the pudding that liquidity is going into the financial markets. It's not going into the real economy."