Central Bank Balance Sheets and Market Returns

A lot has been written about the impact of Quantitative Easing. And while it is arguable whether or not the extraordinary measures taken by central banks have had any significant economic impact, it looks pretty certain that the expansion of central bank balance sheets has helped equity markets.

Fed Returns

Take a look at the graph below. The graph shows the percentage change in the size of the balance sheet of the Fed and the price development of the S&P 500 Index (SPX) since the beginning of 2009. Granted, the S&P 500 index is much more volatile than the balance sheet expansion of the Fed, but it is hard to deny that these two have been moving in tandem in recent years. When the Fed expanded its balance sheet stocks went up and when the Fed stopped intervening aggressively stocks stabilized or fell a bit.

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What about the BoJ and the BoE?

The Fed is certainly not the only central bank that has opted for the growth of its balance sheet to reach its objectives. A good example is the Bank of Japan (BoJ), which has also become a notorious quantitative easer. The BoJ took it relatively easy during first years of the financial crisis. But, more recently the BoJ stepped up its balance sheet expansion efforts dramatically, in what seems to be an ultimate effort by the BoJ to get rid of the structural deflation that cost Japan two decades of economic growth. Since the start of the massive increase of the BoJ balance sheet last year, Japanese stocks (NKY) have performed exceptionally well (see chart below). The same applies to the Fed. The faster the increase in the size of the balance sheet, the better for equities.

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Next up is the UK. Now, here the story is a little bit different. Overall the change in the size of the balance sheet of the Bank of England (BoE) has been accompanied by higher stock prices (BCYIF). But the relationship is not as close as in the US. This has probably something to do with the fact that there were only two distinctive intervals, in which the balance sheet expansion of the BoE took place. Also, the Bank of England has been very explicit about the maximum target amount that would be used for the Asset Purchase Program. The BoE did raise this amount a couple of times, but this was also done within these two intervals. Unlike the Fed and the BoJ the the balance sheet expansion of the BoE has a more ad hoc and less open-ended nature.

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Solitary ECB

Finally, there is the Eurozone. As can be seen from the graph below the relationship between the size of the ECB balance sheet and the local stock market (FEZ) is pretty much absent. Two things are worth mentioning here. First, the size of the central bank balance sheet expansion has been significantly smaller than in the countries mentioned above. Furthermore, in the previous cases the balance sheet expansion qualifies as outright quantitative easing (bond buying). However, the growth of the balance sheet of the ECB the result of the LTRO financing schemes for financial institutions. This is not necessarily seen as quantitative easing. As the ECB stated; ‘quantitative easing à la Fed is a substitute for conventional easing once the policy rate has reached the zero bound, the ECB’s non-conventional operations only aim at ensuring a proper transmission of monetary policy and could conceptually be undertaken at any level of interest rate’. Hence, both the size and nature of the balance sheet expansion by the ECB differ from that of the countries above. That said the ECB did roll out its Securities Market Program (SMP) when the yield on bonds of peripheral countries skyrocketed, but the total amount of bonds bought so far has been very small.

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Relationship across Countries

Now let’s put everything together. The graph below shows both the percentage change in ‘local’ stock markets and the change in the size of the balance sheet for the four countries/regions since the beginning of 2009. Not only does it show that central bank balance sheet expansion has been accompanied by very strong equity returns, it also suggests that more balance sheet growth leads to higher returns. This relationship looks pretty strong as well. The only small exception might be the US. It was the best performing stock market since ’09, but the Fed ‘only’ expanded its balance sheet by 70%, against 76% of the Bank of Japan. But, as mentioned earlier, this good be explained by the steady and ongoing balance sheet expansion in the US during the whole sample period, whereas Japan only recently started to aggressively expand its central bank balance sheet. The Eurozone on the left of the graph is the clear underperformer with the ECB only expanding its balance sheet by 11%.

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Simplistic but Relevant

This analysis of the relationship between central balance sheet expansion and stock markets is very simplistic. Lots of other factors could have influenced the results presented above. For example factors like the different mandates of central banks, the Euro crisis, the health of the local business sector during this sample, currency effects, the correlation of stock markets in general and many, many more. It does not take away, however, that the impact of the central banks policies is better perceived in the stock markets than in the overall economy. Knowing your central bank will probably give you some clue of the (relative) return you may expect.

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