Current chatter among market analysts largely centers economic conditions in Europe and slower, but still robust Chinese growth, as the triggers behind the recent weakness in the S&P 500.

As a counter to the Europe and China stories as the main causes of the weakness we’ve seen since September 18th, take a look at the following graphic.

The figure shows the performance of the S&P 500 overlaid with the expansion in the Federal Reserve balance sheet.

No doubt, there’s a fairly strong connection.

Fed Funds Rate

When QE1 ended in June 2010, the S&P 500 declined around 15% from peak to trough (April to mid-August). (The market was ahead of the curve in anticipating the end of the QE1, akin to current market moves and the expected end of QE3.)

Fed buying treasuries to keep balance sheet constant

A couple months after seeing the economy respond, the Fed announced that it would buy $30 billion in Treasuries to keep the balance sheet constant at $2.05 trillion.

The constant balance sheet idea didn’t do enough in the Fed’s eyes. Thus, in November 2010, chairman Bernanke announced QE2, another $600 billion bond-buying program.

QE2 ended in July 2011. As shown, the market was unpleased with the end of QE2 just as it was with the end of QE1, shedding around 15%.

After watching for a year, on September 13, 2012, the Federal Reserve announced on an 11-1 vote that it would implement QE3, initially at $40 billion per month. The $40 billion expanded to $85 billion soon enough.

After a little less than a year of the continued balance sheet expansion, the Fed, under Bernanke’s leadership, announced a tapering path (June 19, 2013). The initial step was to reduce the monthly bond purchases from $85 billion per month to $65 billion per month.

Given this history, it’s likely unsurprising given that QE3 is coming to end soon, that the market is displeased with the path in which the Fed is heading.

It looks like the market started thinking about the end of QE3 on September 18th, with the S&P 500 down about 4% since then.

If QE1 and QE2 are any guide, the S&P 500 has another 10% to go before reaching bottom.

What will the Fed do if QE backdrops

With the experience of QE as the backdrop, which is more likely to happen first:

  • The Fed increases the federal funds rate; or
  • The Fed implements QE4.

If the consensus view is correct that QE3 ends in November/December, this means the Fed has to make it another 7/8 months until it starts raises the federal funds rate (at least, that’s when the market expects the Fed to raise rates).

Can the Federal Reserve make it to June 2015 without announcing QE4?

Given the sharp shift towards a dovish turn in the Fed’s latest statement, the answer is probably no. The majority of market participants seem to want (perhaps even expect) QE4. We’ll see if the Fed obliges.