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Federal Reserve Holdings and the U.S. Stock Market

Posted in Economic Indicators, Strategic Allocation

Using quarterly data in their April 2013 preliminary paper entitled “Analyzing Federal Reserve Asset Purchases: From Whom Does the Fed Buy?” Seth Carpenter, Selva Demiralp, Jane Ihrig and Elizabeth Klee find that some categories of investors appear to sell U.S. Treasuries to the Federal Reserve and rebalance toward riskier assets (corporate bonds, commercial paper, and municipal debt). Are stocks a part of this process? To investigate, we relate weekly, monthly and quarterly U.S. stock market returns to comparable changes in the Federal Reserve’s System Open Market Account (SOMA) holdings, comprised of U.S. Treasury bills, U.S. Treasury notes and bonds, U.S. Treasury Inflation-Protected Securities (TIP) and Mortgage-Backed Securities (MBS). The Federal Reserve reports these holdings with a small lag. Using weekly (Wednesday close) data for SPDR S&P 500 (SPY) as a stock market proxy and total SOMA holdings during early July 2003 through mid-May 2016, we find that:

The following chart compares evolutions of total SOMA holdings in billions of dollars and SPY over the available sample period. It appears that there is a change in Federal Reserve behavior about the beginning of 2008 from a passive to an active role. Thereafter, an increase (decrease or pause) in SOMA holdings appears to stimulate (depress) the stock market.

In the following analyses, we therefore focus on the subperiod since the beginning of 2008. For precision, we relate SPY return to change in SOMA holdings.

SOMA-SPY

The next chart relates weekly SPY return to same-week change in SOMA holdings since the beginning of 2008. The slope of the best-fit line is positive, so the two series exhibit some tendency to move together. The Pearson correlation between the series is 0.17 and the R-squared statistic 0.03, indicating that a change in SOMA holdings explains about 3% of the variation in weekly stock market return.

Do changes in SOMA holdings predict future changes in the stock market?

weekly-SPY-return-vs-change-in-SOMA

The next chart summarizes Pearson correlations since the beginning of 2008 between weekly SPY return and weekly change in SOMA holdings for lead-lag relationships ranging from stock market return leads change in SOMA by eight weeks (-8) to change in SOMA holdings leads stock market return by eight weeks (8). Results appear to be noise, such that there is no exploitable weekly interaction.

Might an exploitable relationship show up at longer measurement intervals?

weekly-SPY-return-change-in-SOMA-leadlag

The final two charts summarize Pearson correlations since the beginning of 2008 between:

Monthly (4-week) SPY return and monthly change in SOMA holdings for lead-lag relationships ranging from stock market return leads change in SOMA by six months (-6) to change in SOMA holdings leads stock market return by six months (6).

Quarterly (13-week) SPY return and quarterly change in SOMA holdings for lead-lag relationships ranging from stock market return leads change in SOMA by four quarters (-4) to change in SOMA holdings leads stock market return by four quarters (4).

Results suggest that:

  • The Federal Reserve reacts to stock market behavior of several quarters ago to stimulate a weak stock market (by accumulating more securities) or test sustainability of a strong market (by pausing accumulation).
  • The stock market anticipates Federal Reserve accumulation (pause) intervals by about a quarter by advancing (stalling), with the response persisting about three more quarters.

However, the sample is very small in terms of number of quarters and (especially) number of Federal Reserve accumulation and pause intervals.

monthly-SPY-return-change-in-SOMA-leadlag

quarterly-SPY-return-change-in-SOMA-leadlag

In summary, evidence from a very small sample of Federal Reserve initiatives to accumulate SOMA holdings since the financial crisis suggests that: (1) these accumulations gradually stimulate the U.S. stock market (with perhaps one quarter of anticipation); and, (2) suspension of accumulation and liquidation of these holdings depresses equities.

A possible interpretation is that Federal Reserve actions to pull government securities out of the market drives investors toward equities.

Cautions regarding findings include:

  • As noted, the sample is very small in terms of number of Federal Reserve accumulation/pause intervals. Also, persistence of accumulation/pause phases tends to confound statistical inference.
  • Interest rates/rate spreads may intermediate the SOMA holdings-stock market return relationship.
  • Analyses are in-sample (retrospective). An investor operating in real time may discover different relationships at different times.
  • The analyses do not explore any trading strategies based on SOMA holdings, which could use only real-time data.
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