The Fed (Mostly) Didn’t Cause the Latest Stock Market Melt-Up

NEW YORK, NEW YORK – JANUARY 03: Traders work on the floor of the New York Stock Exchange (NYSE) on January 03, 2020 in New York City. Following news that the U.S. military killed Qassem Soleimani, the leader of Irans elite paramilitary forces, global stocks and oil prices fell with the Dow falling over 220 points. (Photo by Spencer Platt/Getty Images) Photo: Spencer Platt/Getty Images

Should Tesla Chief Executive Elon Musk be sending a thank-you letter to the Federal Reserve? Put another way: Is it more than coincidence that Tesla’s stock—and the rest of the market—has soared since the Fed starting buying Treasurys again in October?

Don’t Fight Coincidence

Stocks began a big rally when the Federal Reserve started buying Treasurys again.

Fed says it

will buy bills

Federal Reserve total assets

 trillion

The answer is that the Fed probably isn’t the cause of the stunning rally in Tesla or stocks more broadly, at least in the usual way of thinking about causes. On the other hand, if the Fed hadn’t acted, the market would almost certainly be lower, possibly disastrously so.

The case for thanking the Fed is that in the three months since it started buying bills, the S&P 500 is up 11% and Tesla has doubled. Not only does the timing fit the Fed action perfectly, but something similar happened in the run-up to the year 2000 as the Fed opened a gusher of money to wash away any “millennium bug” year-end dangers, and the dot-com bubble inflated spectacularly.

Jim Bianco, president of Bianco Research, says the Fed’s bill purchases feed through into stocks exactly the way that quantitative easing, or bond purchases, do: via what central bankers call the “portfolio balance channel.” The Fed buys a Treasury security, putting cash into the hands of its previous owner. That person then has to buy something slightly more risky, in turn putting cash into the hands of its owner.

“Everybody takes one step to the right and at the end of the line is small-cap stocks,” he explains. Smaller stocks lagged the S&P 500 until the end of the summer and took off in October, although they have underperformed again since Christmas.

Yet, this mechanical explanation for QE was suspect at the time and remains suspect today. Both the 2010 and 2012 rounds of rising share prices came with rising bond yields, suggesting investors weren’t just being forced out of safe assets, but that demand for the safety of Treasurys was falling. The same thing has happened since October: 10-year yields were already off their lows, but have risen to 1.84% from 1.66% since the Fed intervened.

At the very least, there is no neat step up in demand for slightly riskier assets from those who sell to the Fed; if there were, in this model, Treasury yields should be down or flat as holders of bills buy Treasurys instead.

Back in the QE periods, my preferred explanation was what central bankers call the signaling channel: the Fed’s buying showed it was putting its money where its mouth was, showing both its willingness to act and its commitment to rates staying low for a long time. Stocks, inflation expectations and bond yields duly rose, as financial theory would expect from a dovish Fed move.

The Fed’s latest intervention is different. It isn’t supposed to have any signaling effect, because the Fed insists the bill purchases are just about fixing the chaos that briefly took hold of short-term money markets in September, not trying to change monetary policy.

Yet, there is no denying the rise in the markets. It could just be chance: the U.S.-China trade war calmed down and investor concerns about the economy eased in the autumn, both of which helped stocks.

There are two direct effects of the Fed’s buying which might have helped. First, the Fed took away worries about a broken money market.

In September, the overnight secured borrowing rate of repurchase agreements briefly jumped to 10% from just 2.1% earlier in the month and the federal-funds rate breached the top of the Fed’s target range for the first time since it was introduced at the height of the 2008 financial crisis.

To the extent that investors were braced for money markets to keep malfunctioning, stocks should have been hit by fears that traders could be unable to access the short-term loans they need to hold assets instead of cash. The Fed purchases and its own multibillion-dollar repo program soothed those fears, so probably helped stock markets rise.

Second, the Fed has carried out a hidden rate cut amounting to about a third of a normal 0.25 percentage point cut. Before the money-market panic, effective interest rates were in the middle of the Fed’s range, both for interbank lending in the federal-funds market and for overnight repo. Both were slightly above the interest rate the Fed pays banks on excess reserves.

That has changed, with the Fed cutting the rate it pays to be to just 0.05 points above the bottom of its range, while the interbank rate no longer trades above it and overnight repo has shifted to be at or slightly below it. Money is just that bit cheaper, which should support stocks a little.

Neither of these justifies a solid year’s worth of stock-price gains in three months, let alone the doubling of Tesla’s shares. Investors might be treating the Fed action as signaling even more dovishness, or—my own theory—shares have mostly gone up for other reasons. Either way, Mr. Musk should probably save his thank-you notes for someone other than Fed Chairman Jerome Powell.

The repo market shook the financial world in September when an unexpected rate spike choked short-term lending, spurring the Federal Reserve to intervene. WSJ explains how this critical, but murky part of the financial system works and why some banks say the crunch could have been prevented.

Write to James Mackintosh at James.Mackintosh@wsj.com

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