The stock market has been a roller coaster since October. Equities took a nose-dive in October. They then rallied in early November. Fell again steeply in December. Finally, stocks rallied strongly in January. However, the same market forces that knocked stocks down late last year will trigger stock volatility to return in February.
First, we need to understand what’s driving the volatility in this market. At its most basic level, supply and demand drive the stock market. In this case, the shares of public companies traded on exchanges is supply. The demand is the amount of investment capital available to purchase these shares.
The supply of public shares tends to remain more or less constant in the short term. However, demand in the form of investment capital can fluctuate wildly. Indeed, stock market volatility started as investment capital drained out of financial markets in October.
The Federal Reserve’s Quantitative Tapering is Wreaking Havoc in the Stock Market
The culprit is the Federal Reserve’s quantitative tapering program. The Fed is essentially pulling some of the money it printed in the aftermath of the Financial Crisis out of the markets. The amount varies month-to-month but is capped at $50 billion per month.
When the Fed pulls out too much money, it causes the stock market to stumble. Indeed, we can see this illustrated in the tables below. The first table provides the projected Fed balance sheet’s quantitative tapering broken down by week. The column UST stands for US Treasuries while MBS stands for mortgage-backed securities. These are the two main types of securities that the Fed bought up during its quantitative easing program. All values are in billions.
The Fed pulled out large amounts of money in the two weeks highlighted in green. They roughly coincide with the declines in October and November highlighted in the S&P 500 chart below.
The fall in October started a little before the end of the month. However, this is likely due to traders front-running the Fed’s tapering.
It’s also important to note that the big decline at the end of December happened during Christmas week. Typically, liquidity dries up during the holidays as investors take off. The Fed taking out more money at the end of December likely exasperated this lack of liquidity.
Stock Volatility to Return in mid-February
The Federal Reserve is set to take out another large chunk of money in the third full week of February. The Fed balance sheet will run off some $23.3 billion worth of US Treasuries. At the same time, another $7.4 billion worth of mortgage-backed securities is also running off.
That’s a sizable $30.7 billion worth of liquidity that financial markets will have to replace that week. Typically, this happens by investors pulling money from riskier assets like stocks and moving it into risk-free assets like US Treasuries. Hence, equity markets getting hit hard as liquidity runs dry in financial markets.
Traders at big investment firms know this already and will likely try to get ahead of the trade. Accordingly, investors can expect stock volatility to return in February.
Moreover, this volatility will likely get exasperated by the fact that the US Treasury will issue a hefty $365 billion in Treasuries this quarter. Essentially, financial markets will bleed another $120 billion worth of liquidity in February assuming an even distribution of issuances.