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By Scott | Published on September 4, 2024
Major U.S. stock indices fell ~10% in early August following a disappointing July jobs report. This news was followed up later in the month by an announcement from the Fed Chair at the annual Jackson Hole summit that the "time has come" for policy to adjust. This was the strongest signal yet that he’s seen enough labor market cooling for the Fed to begin cutting rates at the Fed’s next official policy meeting on September 17-18.
Yet, stocks are back near highs after rallying to finish the month not far from where they started. The S&P 500 climbed 2.3% from the end of July, leaving it just shy of its record close. The Dow Jones Industrial Average rose 1.8% for the month, and the tech-heavy Nasdaq Composite ticked up 0.6%. On a yearly basis, the major indices have performed well, with the S&P 500 up 18%, the Dow Jones Industrial Average up 10% and the Nasdaq Composite up 18%.
Investors currently pencil in a 69% probability that the Fed will cut rates by a quarter percentage point at its next meeting, while 31% predict the Fed will cut rates by a larger-than-normal half percentage point. Is there a case to be made that the Fed should not cut rates at all? We explore this question below.
Broad financial conditions are considerably easier today than when rates were at zero in March 2022. The Chicago Fed’s National Financial Conditions Index (NFCI) provides a comprehensive weekly update on U.S. financial conditions in money markets, debt and equity markets, and the traditional and “shadow” banking systems.
The NFCI decreased to –0.55 in the week ending August 23. The NFCI is constructed to have an average value of zero and a standard deviation of one over a sample period extending back to 1971. Positive values of the NFCI have been historically associated with tighter-than-average financial conditions, while negative values have been historically associated with looser-than-average financial conditions.
The Fed insists on characterizing its policy as “restrictive,” but borrowers issued $50.2 billion in loans to fund dividend recaps in the year to date through Aug. 12. These are the distributions that the private equity promoters pay themselves, not out of cash flows but by borrowing. It’s the second-highest year-to-date tally since at least 2006, and it trails only that of 2021.
Encumbered businesses are completing these deals by way of the accommodative debt markets & the fact that money is not tight. It’s actually still loose. S&P Global Ratings upgraded its speculative-grade default forecast, and this sentiment in the market has been reflected in the falling spread, or extra yield, that investors demand to hold corporate bonds over Treasurys. Bigger fears lead to larger spreads to make up for the greater risk of corporate defaults, and right now, investors don’t seem worried as bond spreads remain tight by historical standards.
There used to be a near perfect correlation between the total amount of US currency in circulation and the size of the Fed’s portfolio. This stopped when the Fed adopted QE, and its securities holdings began to exceed the amount of US currency. The Fed had begun to do some quantitative tightening (QT) in the late 2010s, but resumed its money printing following the pandemic. Today, the number of dollar bills used by the global economy stands at $2.3 trillion, but quantitative easing (QE) has resulted in a balance sheet for the Fed that has ballooned to $7.1 trillion. Thus, the government had been printing money to the tune of $4.8 trillion. It should be no surprise that inflation spun out of control during this run-up in printed money in 2021. Rather than continue the monthly runoff pace of $60 billion in Treasurys per month from its balance sheet, the Fed decided in May to reduce the cap to $25 billion per month. This decision to slow QT threatens the risk that inflation reappears - nevermind the implications on inflation from a potential decision later this month to outright cut rates.
The Fed’s asset purchases significantly expanded the money supply, which means its policy regime matters to the path of inflation. Outsize changes in the monetary base and the quantity and velocity of money have an important bearing on the ultimate price level.
The surge in federal spending and resulting central-bank asset purchases in 2021 and 2022 contributed to a surge in inflation. The monetary base is up 60% since the pandemic. The inflation surge over the same period—cumulatively about 22%—shouldn’t have been a surprise.
The Fed shrank its balance sheet in the past few quarters, down 7 percentage points from its peak as a share of GDP. M2 is down about 3%. The result was highly predictable: less money printing, less inflation.
Deposits (money) are created by the private banking sector through loan creation. A bank takes a piece of collateral as an asset and creates a deposit (a liability to the bank) in return. At the moment though the banking system is well capitalized.
Usage of the Federal Reserve’s Reverse Repurchase (RRP) Agreement Facility has declined 87% since the end of 2022. This drawdown has added cash to the financial markets and more than offset any attempt at belt tightening from the Fed’s policy to roll off $25 billion in Treasurys and $35 billion in agency paper from its balance sheet.
Since the start of the year, Fed securities portfolio declined by $510 billion and RRP by $727 billion. Net impact of these offsetting actions has helped push up bank reserves by ~$200 billion since Dec 2023.
As a reminder, the RRP was created to sop up excess liquidity - the cash that commercial banks and money-market funds park here is inert since it can neither be lent nor serve as collateral to finance a securities purchase. At current pace, RRP will be empty by end of March 2025. This is the point at which Fed’s QT program will actually begin to drain liquidity from the banking system
These facts may have helped to catalyze the decline in the 10-year Treasury yield to 3.77% from 4.63% in May, which set stock prices on fire and compressed high-yield spreads.
The jobs data for August due tomorrow could set the tone for the rest of the year. A report showing strong hiring could give a huge lift to markets, while the opposite could set off new recession alarms and lasting volatility.