Have You Been Fooled By This Chart? QE vs Stocks
The chart below has to be one of the most famous, and circulated, charts of the past decade.
Countless people have observed that both data sets dovetail nicely in an upward trajectory, and come to the conclusion that the stock market is rising because of the Fed’s massive expansion of bank reserves.
However, what they don’t know is that QE is nothing more than a right-pocket-to-left-pocket asset swap.
Putting it another way: No money was created in this transaction.
The premier form of money used in the financial system, US Treasuries, was taken out and replaced with bank reserves, a form of money that can only be used by banks and no one else in the wider economy.
Bank reserves are used by banks to settle transfers between themselves on behalf of their customers like you and me. While this is, without doubt, an extremely important economic function, it has no direct bearing on the equity markets.
This is because bank reserves very rarely make it to trading accounts that purchase stocks (like asset managers or individual traders).
Bank reserves sit on the balance sheets of banks… and stay there.
But why can’t banks purchase stocks directly?
Surely because of the correlation that has to be what is happening?
Banks will not purchase stocks (or for that matter fixed income instruments deemed to be “risky”) for the same reason any well managed corporation will not purchase stocks with their cash balances* – they are NOT in the business of speculating in equity prices!
Banks are in the business of banking, just as McDonald’s is in the business of serving fast food. McDonald’s doesn’t invest its cash balances into stocks, so why would banks?
It also isn’t a matter of “McDonald’s isn’t involved in finance and can’t understand markets”. It is however, a matter of not taking excessive and needless risk with what is ultimately, shareholder’s money. (It must be noted that Tesla is a notable exception, with the company investing in Bitcoin)
Over the years, it has been possible for some amount of the Fed’s liquidity to end up in fixed income markets, and possibly (although unlikely), even equity markets. If the Fed purchased Treasuries and/or Mortgage Backed Securities directly from asset managers instead of through the primary dealers (banks), the asset managers would have reinvested the proceeds back into the markets.
However, most of QE has been transacted through the primary dealers, which means bank reserves stuck on bank balance sheets.
No torrents of liquidity flowing into equity markets then. But if this isn’t the case, why is “QE juices stocks” such a popular narrative?
The first reason would be the obvious one, a simple misunderstanding of what QE is and is not, how the Fed transacts the programs, what bank reserves are and are not, how the financial system works in reality, etc.
The second, and much more powerful reason, is paradigm. Market participants have been trained too well, since the days of Greenspan, that when the Fed says its programs and policies support markets, that’s actually what happens.
They believe that the Fed will achieve what it says its policies are supposed to achieve, because that is how the Fed says the system works, and that is how the textbooks say the system works.
Since paradigm is the deepest and most difficult part of a complex system to change, every new episode of QE results in the same manic bidding up of all risk assets.
Correlation really doesn’t equal causation. In the case of QE and stocks, given the outsized influence a complex system’s paradigm has on its future paths, what happens when the paradigm switches from belief to disbelief?
*Corporations can and do purchase stocks when they are looking to take minority stakes in other companies, but this is a business decision, not a “let’s buy stocks to earn more yield on our cash balance” decision.
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