What Happens When the Fed’s Balance Sheet Gets Smaller?

Wednesday, February 1, 2017 |

There has been a very high correlation between the size of the Fed’s Balance Sheet and the US Stock Market since 2009 when the Fed started their expansionary quantitative easing (QE, where the Fed bought longer dated Treasuries to push down longer interest rates) program:

Source: Capital Advisors, Ltd.

The Fed ended QE in late 2014; however, it continues to reinvest the proceeds from the bonds it already purchased.  When will this end?  Market participants are eyeballing April 2018.

Source: The Daily Shot, @enlundm, Nordea Markets

The above charts lend to some concern at the end of this year.  What will happen when the Fed starts shrinking their balance sheet?  Off the top of my head, I can think of a few things that could offset this reduction:

  1. Other central banks (ECB, Bank of Japan, BOE, etc.) continue their expansionary policies
  2. The US consumer starts to add to their balance sheet (i.e. increase leverage)
  3. Increase in fiscal policy (tax cuts, spending)

What will ultimately happen to US stocks when the expansion ends is unclear.  But whatever the outcome, it will filter through the economic and earnings data and focusing on the data is likely preferable to guessing.