In response to the many questions raised by our readers, this week we return to the chart that has obviously been the subject of much debate. This is the overlay between the Fed's balance sheet, in red, and the performance of the S&P 500.
Since 2009, inflation in financial assets has been perfectly correlated with the massive injection of liquidity into the global financial system, culminating in the Covid crisis. Since 2022, however, we have witnessed the opposite phenomenon: the Fed is reducing its balance sheet, while equity markets have almost doubled in size. This raises the question of whether the shrinking money supply will eventually weigh on the equity market.
To understand the mechanisms at work, it's important to review a few points. The Federal Reserve has two main levers for stimulating or slowing the economy: setting short-term interest rates (long-term rates are set by the market) and adjusting the money supply.
Traditionally, when the Fed lowers interest rates, it stimulates the economy (and consequently the stock market). Conversely, when it raises interest rates, it aims to curb the economy (and inflation), often resulting in a decline in equity markets.
The Federal Reserve can also adjust the money supply, by creating or destroying money. Note that money creation is not the role of the government, but of the central bank. Schematically, the Fed creates money, which it then distills into the economy by buying Treasury bills. Conversely, it sells its bonds when it wants to reduce the money supply. And that's exactly what it's been doing for the past few years, which explains the tension observed in interest rates (which move inversely to bond prices). The more bonds you want to sell, the higher the yield you demand.
So we find ourselves faced with a paradox: at the same time, the Federal Reserve is cutting interest rates while reducing the money supply. Interest rates have risen as a result of three factors:
The Fed's massive bond sales The expected rise in inflation The rise in government spending
As mentioned last week, investors should logically expect equity markets to consolidate to make their yields (dividends) more competitive than those generated by bonds. However, this is not the case.
Why is the equity market so resilient?
Firstly, the behavior of the S&P 500 is closely aligned with corporate earnings forecasts. It is therefore entirely possible that growth will continue at current levels, or even accelerate without inflation, provided that strong productivity gains are achieved through the adoption of artificial intelligence, blockchain and robotics.
Investment spending by the tech giants in both manufacturing (notably data centers) and AI has risen sharply in recent years. But will they be accompanied by productivity gains in the near future? For the health of the stock market, they'd better be, especially as a newcomer, DeepSeek, could well reshuffle the deck.
This week, we'll also be focusing on traders' reactions to the Federal Reserve's meeting scheduled for Wednesday, while the ECB will unveil its monetary policy on Thursday.
