Have you ever been through a market crash? I've read about market crashes, such as the early 2000s tech bubble burst and the 2009 sub-prime mortgage crisis, but I've never experienced one until 2020 Feb. When the market fell -5 percent on a daily basis, the exchange halted stock trading, and the market stopped moving like a corpse. It was terrifying because no one knew whether it was the end or just the beginning. The market was shut down again the next day, and it felt like you were driving a car with a broken brake pedal. You were aware that it was heading in the wrong direction but had no idea how to stop it. The price of stocks was moving violently as the investor's heart rate increased. Everyone in the market felt weak and helpless as a result of the market's floorless free fall and volatile price movement. The market was in desperate need of a superhero who could stop the falling car and save us. There was also the Federal Reserve.
The Federal Reserve intervened with a wide range of actions to limit the economic damage caused by the pandemic. The market was stabilized and turned upward as soon as the Fed intervened. It worked like a charm. The Federal Reserve created dollars out of thin air with a few keystrokes on a computer, effectively "printing" money and injecting it into the commercial banking system. The Fed's announcements and responses brought the market to a halt. The market required a true superhero. Without these, the economy would have already crashed.
The Fed's method of injecting money into the economy
The Federal Reserve does not physically print paper dollars; that is the responsibility of the United States Treasury. Instead, the Fed purchases large amounts of assets on the open market by depositing newly created electronic dollars in the reserves of banks such as Wells Fargo, Goldman Sachs, and Morgan Stanley, and it receives large amounts of bonds – U.S. Treasury securities and agency-backed mortgage-backed securities (MBS).
As a result, markets that had become clogged began to flow again. Banks have more dollars in reserve and are more likely to lend money without fear of running out of funds due to a panicked run on the bank. The Fed's actions effectively increase the money supply while lowering interest rates.
To assist businesses and taxpayers, Congress has passed massive spending bills that have increased the national debt by approximately $2.4 trillion, which was financed by the issuance of U.S. Treasury securities. Since mid-March 2020, the Fed has purchased $1.4 trillion in Treasuries out of a total of $1.6 trillion issued during that time period. It did not, however, purchase securities directly from the US Treasury. Instead, it used commercial banks to purchase previously issued Treasury securities.
The Fed is printing money in order to purchase government debt in the form of securities previously issued by the United States Treasury. The Treasury then pays the Fed the interest it owes on the securities. In turn, the Fed is required by law to return to the Treasury any profits made on Treasury securities purchased. By doing so, the Fed creates money for loans, ensuring that credit continues to flow to households and businesses during this difficult period and that the financial system does not amplify the economic shock.
As part of its fiscal stimulus programs, the Fed has not purchased stocks. However, its near-zero interest rates and credit support for large swaths of Corporate America have enticed yield-hungry investors to return to the equity market.
How much money did the Fed put into the market?
The Fed has been buying about $120 billion in Treasury bonds and mortgage-backed securities each month. As of November 2, 2021, its balance sheet had ballooned to $8.57 trillion US dollars. According to the balance sheet trend chart, the Covid stimulus has increased its balance sheet by $4.5 trillion since February 2020.
That was an excessive amount of money supply injected, but it was necessary for this unprecedented period. However, we are all aware that it is time to control the money supply in order to prevent inflation from harming the economy.
How long will the Fed keep stimulating the economy?
The Fed's massive debt purchases were always expected to be reversed once the economy had recovered sufficiently from the pandemic. The good news is that the economy is gradually returning to normal as more people get vaccinated, return to work, and, in many ways, resume their lives prior to the pandemic. This implies that the Fed's debt purchases must be reduced, or tapered.
What will happen when the Fed begins to taper?
Starting in November 2021, the Fed announced that it would begin reducing asset purchases by $15 billion per month (cutting Treasurys by $10 billion per month and mortgage-backed securities by $5 billion). If it continues at this rate, the program will be completed by the middle of 2022. Wall Street should not be surprised, as the Fed has been signaling to investors for months.
The Federal Open Market Committee anticipates three more hikes in 2023 and 2024, bringing the Fed's benchmark borrowing rate to a range of 1.75 percent to 2 percent, up from its current range of 0 to 0.25 percent. The Fed will proceed with caution before raising rates, and will most likely wait until tapering is complete, but the market will be looking for more hawkish cues.
Members of the FOMC raised their 2021 core inflation forecast to 3.7 percent, up from 3 percent in June. Things could become more complicated if inflation continues to exceed the Fed's expectations. Inflationary economic conditions and tapering news will begin to push yields higher, pushing the benchmark 10-year Treasury to 1.8 percent by the end of 2021. That's about 40 basis points higher than it is now, but it shouldn't have a significant impact on borrowing costs for businesses or individuals. Yields move in the opposite direction of prices, implying that investors will sell bonds in anticipation of higher rates and less Fed support.
While higher bond yields reduce the relative attractiveness of equities, the positive impact of rising earnings as economies return to normal should more than offset the negative impact of rising bond yields.
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