The Fed’s Balance Sheet: What you Need to Know

The Fed plans to reduce bond holdings and increase interest rates in 2022. History tells us gold is one of the strongest assets in this environment.

Key Takeaways:

Yesterday’s FOMC meeting minutes signaled another hawkish pivot toward interest rate increases and deleveraging, or reducing the value of bonds held by the Fed.
Stocks, bond prices, and gold all took a hit. The S&P 500 was down 2.38%. The tech-heavy Nasdaq 100 was down almost 4%.
Gold’s most recent breakout began in August 2018, right in the middle of the Fed’s last bout of deleveraging. Could history repeat itself in 2022?

A Hawkish Fed Takes a Swing at Stocks

The Federal Reserve inflicted damage across stocks, bonds, and precious metals this week with another hawkish pivot. On December 15th, the 12 members of the Federal Open Market Committee (FOMC) met to discuss raising interest rates and reducing the Fed’s balance sheet.

The meeting minutes, which were released yesterday, signaled an interest rate increase as soon as March of this year. The committee also suggested reducing the central bank’s $8.76 trillion portfolio sooner than expected – another form of tightening monetary policy.

The news knocked the S&P 500 down 2.38% and the Dow Jones Industrial Average down 2.02%. Bond prices dropped. Yields were up. The hawkish pivot had the biggest impact on technology stocks, which are currently trading at extreme valuations compared to earnings. As interest rates rise, investors lose their appetite for risk.

Gold is down 2.16%. So far, the price has stayed above the Point of Control at $1,788, which is a good sign that this could serve as a price floor.

The Fed’s Balance Sheet: What you Need to Know

The chart below shows the total value of Treasuries and mortgage securities held by the Fed, a.k.a. the Fed’s balance sheet. The Fed purchases bonds to increase the money supply in a process called quantitative easing.

The Fed has more than doubled its bond holdings over the last two years. We already know the Fed plans to stop purchasing new assets this year, but they still need to decide what to do with the $8.76 trillion they already own.

There are two options: 1) The bank could keep holdings steady by reinvesting bond proceeds into new bonds. Theoretically, this neither stimulates nor suppresses economic growth. 2) They could let the bonds mature or run off, therefore reducing total holdings. This would resemble the period of “de-leveraging” from early 2018 to late 2019.

Judging from the yesterday’s FOMC meeting minutes, the Fed is going for option 2.

What does this mean for stocks?

Judging from the reaction yesterday, you can probably guess that stock investors aren’t happy. The Fed balance sheet has basically dominated stock performance since the Great Financial Crisis. When the Fed pumps money into the economy, that money funnels into stock prices. Just look at the S&P 500 on top of the balance sheet chart:

During the period of deleveraging from early 2018 to late 2019, the S&P 500 was basically flat (dismal returns compared to the last two years).

Contrast this with the explosive growth in the stock market and the Fed’s balance sheet in the last two years. The balance sheet increased 112% since the COVID recession. The S&P 500 has increased 108%.

What does this mean for gold?

During the same 2018-2019 period of balance sheet deleveraging, gold rose 17.88%.

It is important to note that gold’s most recent breakout began in August 2018, right in the middle of the deleveraging episode. Not to mention, other hawkish pivots in monetary policy also look good for gold. Hikes in the Fed Funds rates have been bullish for gold over the last 20 years. The beginning of the last rate hike in early 2016 correlated perfectly with gold’s bear market bottom.

Which asset are you banking on during the next phase of deleveraging? I’ll take gold, thank you very much.

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As always, thank you so much for reading – and happy investing!