The stock market is trading at a record high, but investors continue to fear rising rates and inflation. The lack of market liquidity during the summer doldrums and the higher economic numbers may force the FED to taper or reduce the rate the central bank accumulates new assets on its balance sheet. Tapering may come as early as the end of the year as the FED unwinds or draws down its monetary stimulus of the past couple of years.
While economic numbers and other statistics may partially influence the near-term directions of the US economy and the stock market, it is the FED's action that will be the single most important factor driving the stock market during the second half of the year.
The FED balance sheet is a weekly report that lists the Federal Reserve's assets and liabilities. The report highlights the FED's expansion or contraction of its balance sheet via its monetary policy. Historically, the Federal Reserve's balance sheet has expanded and contracted over time.
Before the 2007-2009 global financial crisis, the total assets held by the FED stood at $870 billion (August 2007). By early 2015, the FED's balance sheet has exploded to a historical high of $4.5 trillion. A normalization program from October 2017 to August 2019 resulted in the total assets declining to just under $3.8 trillion. However, starting in September 2019, the total assets began to expand sharply higher, reaching the current record high of $7.94 trillion (6/2/21).
Before the global financial crisis, the FED would control the economy and the stock market in subtle ways, adjusting short-term interest rates (i.e., FED funds rate) to stimulate or restrict economic activities. However, soon after 2009, the FED has dramatically altered its monetary policies by injecting massive liquidity and support into the banking and financial systems via the QE1, QE2, and QE3 programs.
The start of the COVID-19 pandemic led to an unprecedented QE4 program or the fourth round of quantitative easing by the central bank since the global financial crisis a little more than a decade ago. The continuing QE program at a rate of over $100 billion per month is stimulative to the economy resulting in inflation rising to 5% from a year ago.
As a stock investor, the monetary stimulus from the FED and the massive fiscal stimulus programs from Congress have helped stocks skyrocketed to new record highs. The trend will likely continue if the FED and Congress continue to be accommodating.
There does not appear to be any doubt from most market pundits and investors about what will happen when QE4 ends. We know from the prior three QE programs, that the stimulus was great for stock investors.
We also realize that when the FED tapers it has resulted in stock market corrections. For instance, the end of QE1 led to the early May 2010 Flash Crash sell-off. Again, the ending of QE2 triggered a deep stock market correction that fell just short of a bear market (19%) during July 2011. The end of QE3 also resulted in a delayed reaction, as the withdrawal of liquidity led to the late-2015 China-induced crash which also impacted US stocks.
Will another market correction occur when the FED announces the next tapering to the QE4 programs possibly later in the year or early 2022?