From Deutsche Bank's Jim Reid
The recovery from the lows after Bullard spoke yesterday is another reminder how addicted markets still are to liquidity. Indeed in today's pdf we reprint and update a table from our 2014 Outlook showing the various phases of the Fed's balance sheet expansion and pausing over the last 5-6 years and its impact on equities and credit. We have found that the relationship broadly works best with markets pricing in the Fed balance sheet move just under 3 months in advance. We've also included our oft-used chart of the Fed balance sheet vs the S&P 500 to help demonstrate this. So end July / early August 2014 was always the time that this relationship suggested markets should enter a new more difficult phase.
With this lag, the table rather neatly shows the pulsing reaction of credit and equities to the growth and pauses in the growth of the Fed balance sheet around the Lehman demise, QE1, QE2 and QE3. After the initial emergency expansion of the Fed balance sheet in 08 where risk assets still declined (they would have declined much much more without it) we have alternated between aggressive balance sheet growth and large to huge risk-on on one hand, and small balance sheet run-off and risk-off on the other. This period post the end of July is just the latest evidence that this pattern is real. So we still think central bankers hold the key to markets going forward and there seems to be a hint of change in the Fed.