This Is Why Janet Yellen's Jackson Hole Speech Could Destroy the Stock Market
The stock market is up well over 200% from its low in March 2009.
How did we get this kind of rally? It turned out the Federal Reserve had some tricks up its sleeve. The flashiest trick - the one you are probably most familiar with - was cutting interest rates to near zero. Lower interest rates made it cheaper for big and small businesses to borrow money, invest in themselves and hire more workers.
But the Fed's other big trick here was something called quantitative easing. The Fed bought bonds - lots of bonds - and they bought them mostly from banks.
So, why was the Fed so desperate to help the banks at that point?
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Because banks could now use the proceeds from selling bonds to the Fed to lend out money to people like you and me, and businesses of all sizes.
The hope here is it will lead to more jobs to chip away at that sky high unemployment.
But, the Fed's balance sheet is now about $4.5 trillion, compared to about $1 trillion before the crisis. This year, this Fed has essentially vowed to start shrinking its balance sheet.
Why? The economy is growing!
Unemployment is quite low, companies are earning more money and it's getting harder to argue that the economy needs the Fed's help. The Fed's most recent minutes report said the central bank is likely to start unwinding its balance sheet as soon as September.
Once it pulls the trigger, the Fed said it would start dropping about $10 billion per month. They told us this back in June. At that rate the Fed would shed just $120 billion per year.
So in the grand scheme of things, the Fed is shedding these assets incredibly slowly.
But just the notion of a smaller Fed balance sheet could cause plenty of stock market volatility.
Because the Fed's spending over the past few years pushed investors into the stock market. The return on other assets, like bonds, became much less attractive - thanks to the Fed.
When the Fed buys bonds, their prices go up because there's more demand. When bond prices go up, the interest rate you get on the bond goes down. We know bond prices and their interest rates move in opposite directions.
So investors flocked to riskier assets, like stocks, to get a better return on their money. Some have accused the Fed of creating an asset bubble in stocks. Those critics may be right.
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The worries about what life will be like with a smaller Fed balance sheet are valid. Will it cause investors to take their cash out of the stock market and jump into safer assets like bonds? We just don't know.
But many analysts say that even after the Fed's unwinding process, its balance sheet will still be way above pre-recession levels - giving constant life support, albeit a little less, to the markets.
So here's my take on all of this:
The Fed has done a great job in boosting the stock market - but it hasn't helped everyone. The 2008 crisis scared too many people away from the stock market.