The Bond Market and the Federal Reserve Don’t Control the Stock Market
In the years following the 2008 Global Financial Crisis, the Federal Reserve cut short-term interest rates to the zero bound and engaged in “quantitative easing (QE)” to apply downward pressure on long-term interest rates. To execute QE, the Fed bought long-term Treasurys and mortgage-backed securities in very large numbers, ballooning the central bank’s balance sheet in the process. Popular thinking about these measures was that investors were forced into risk assets since yield was diminished in fixed-income markets.1
The Fed’s Balance Sheet – Expands Throughout the 2010s, Soars in 2020
I’m not saying this line of thinking is wrong. Easy money supercharged capital flows into stocks and other risk assets. Investors in search of yield had limited options in the bond markets, and massive amounts of liquidity meant more money was sloshing around in the capital markets. Much of it made its way into stocks.
But the thinking that the Fed was the only reason stocks did well in the 2010s and after 2020 is flawed, in my view. If this theory were true, it would mean quantitative tightening (QT) and rising interest rates would in turn be bearish for stocks, right? But that’s not what we’re seeing.
The Fed’s balance sheet peaked in April 2022 and has fallen by nearly $1.5 trillion since then. In that time, bond yields have also marched higher, with the 10-year U.S. Treasury bond moving from approximately 2.30% to its current 4.10%. So taken together, we have nearly two years’ worth of quantitative tightening on the books, with bond yields nearly doubling in that time. This prolonged tightening period should have been treacherous for stocks. But it wasn’t.
We know that 2022 featured a bear market, but it ended in October of that year while QT, aggressive rate hikes, and rising bond yields were ongoing. As seen in the chart below (pay particular attention to the green box), the Fed’s balance sheet (blue line) has been progressively shrinking – save for a brief uptick during regional bank stress – while the stock market (red line) has been rallying strongly.
In 2024, bond yields have been moving modestly higher, which many would assume should factor as a negative for stocks. But stocks have managed to hit new all-time highs in the new year. The point to make once again is that falling bond yields and QE were not solely responsible for stocks’ strong gains over the past 15 years or so, just like rising bond yields and QT should not prevent stocks from reaching new all-time highs.
Bottom Line for Investors
The argument that the Fed and bond yields matter immensely to stock market performance is missing something glaring: the role of corporate earnings and economic growth. Aggregate S&P 500 earnings-per-share grew steadily from 2009 to 2015, contracted slightly, and then trended sharply higher up until the end of 2019. Aggregate EPS for S&P 500 companies more than doubled in this period, with profit margins reaching their highest point in decades by 2022. Zooming out even further, we know that year-over-year operating EPS growth averaged 7.1% from 2001 to 2022, which is almost perfectly in line with the S&P 500’s 7.01% annualized return over that same period.4 In short, stocks were propelled by much more than just the Fed and will continue to be as QT continues, in my view.5
Disclosure
2 Fred Economic Data. February 29, 2024. https://fred.stlouisfed.org/series/WALCL#
3 Fred Economic Data. February 29, 2024. https://fred.stlouisfed.org/series/WALCL
4 J.P. Morgan. 2024. https://am.jpmorgan.com/us/en/asset-management/adv/insights/market-insights/guide-to-the-markets/?gclid=Cj0KCQjwmICoBhDxARIsABXkXlKEwzu1pOK4ldrG0WzcPVDn1jeam7dSUKFu_7tFO9SbwNAwzFwb9aMaArH1EALw_wcB&gclsrc=aw.ds
5 Moneychimp. 2024. http://www.moneychimp.com/features/market_cagr.htm
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