September 19, 2021

Monetary Regime Risk

When central banks pump trillions of dollars into the financial system, it's easy to feel investment genius.Indeed, in a growing market, the investment strategy is extremely simple. But as inflation rises, we can see that the Federal Reserve will at some point try to cut back on the program to support the economy through the purchase of securities. What are the risks for investors in this case?

Think back to March 2020. COVID is hitting the US, and the stock market, which until then has completely ignored the spread of the disease, is responding with a big correction.

The S & P500 falls 35%.

But this correction was not limited to the stock market only. The reason is simple:

  1. Investors did not expect a big fall, instead many were building up long positions through margin lending.
  2. When the fall occurred, all leveraged investors had to face margin calls.
  3. But in order to raise the necessary funds to meet these requirements, they were forced to sell some other assets.
  4. As a result, everything (even gold and bitcoin) was sold out in order to get the necessary liquidity.

In a liquidity crisis, everything eventually becomes interconnected.

Correlation of BTC, SP500 and gold

Obviously, the Federal Reserve doesn't like it when the stock market falls. From their point of view, the stock market is an economy.

However, they have an easy way to fix this: just print money, buy assets with it and pump the market with liquidity.

Fed balance sheet 2008 versus 2020

In just a few weeks of last year on the balance sheetThe Fed added nearly $ 3 trillion in assets. Now that figure has risen to $ 4 trillion and continues to grow. This is more in scale than in all the previous 12 years following the 2008 financial crisis.

With financial markets drowning inliquidity, the stock market regularly breaks new records. For reference, the SP500 is up 34% during this time from the top set BEFORE the March 2020 correction.

But as we just said, this bull marketfueled by the printing of money, which means that one of the main risks for it is a reduction in the quantitative easing program. And who knows if we might have another liquidity crisis that will crash Bitcoin as a result.

Can we quantify this risk?

Well, let's try.

There are two types of monetary conditions:

  • expansion, that is, the Fed expands its balance sheet;
  • contraction, that is, the Fed is reducing the size of its balance sheet.

To compare these two modes, under the extension wewe mean the growth of the FRS balance on average over the previous 4 weeks, and by reduction - on the contrary, the reduction of the balance on average over the previous 4 weeks.

Now, what interests us is the episodes of the stock market decline. Let's see what the market situation looks like depending on the monetary regime.

We will use the SP500 as a yardstick for the stock market and focus on the period starting January 2007.

First, let's distribute the market drawdown episodes by size.

Take a look at the graph.

Each point is a drawdown.The horizontal axis shows the size of the drawdown, which is a percentage drop from the historical maximum to the minimum. The drawdowns that occurred during the expansion phase of the Fed's balance sheet are shown in green, and those that occurred during the contraction phase are shown in red.

Stock market drawdown

At first glance, there is not much difference between the two modes. Drawdowns of all sizes were observed both there and there. In both cases, the bulk of the drawdown is concentrated below the 5% mark.

What if you add the duration of each drawdown to the chart?

In the chart below, the size of the drawdown is shown along the vertical axis (in reverse order), and the duration is shown along the horizontal axis.

Stock market drawdown

So, if you look at the upper left quadrant (shorter duration and lower amplitude), there is not much difference between the two modes.

But if you go to a longer oneduration, red dots will begin to prevail. I think this is pretty intuitive. After all, when the Fed is not adding liquidity, it takes longer to get out of the drawdown.

Now, to quantify the risks of changes in the monetary regime, the following question should be asked:

How likely is a correction to follow when the Fed shrinks its balance sheet?

Since 2007, we are more often in expansion modebalance of the Fed than in the mode of its reduction. So, you need to quantify: the ratio of the number of trading days spent in each mode, and how statistically more frequent is the correction during the reduction mode?

Here's what happens:

Stock market drawdown

If we take into account all the sizes of corrections, then during the phase of contraction, collapses occur 30% less often than during the phase of expansion.

It actually makes sense because more severe corrections tend to occur more frequently during contractions:

  • drawdowns of more than 5% happen 30% more often,
  • drawdowns of more than 10% happen 60% more often,
  • Drawdowns of more than 20% happen 40% more often.

So when the Fed does not fill the market with liquidity, the chances of getting more significant corrections increase.

If we assume that corrections with an amplitude of more than10% will most likely affect other markets, then the risk of a negative impact on the bitcoin rate in the event of a reduction in the Fed's balance sheet increases by 60%.

It is worth making a reservation here that we have had enough for now.are far from cutting the Fed's program, and as you know, Jay Powell is vague enough in his statements to suggest that this may not happen and never at all.

However, all the risks should be borne in mind.

BitNews disclaim responsibility forany investment advice that this article may contain. All the opinions expressed express exclusively the personal opinions of the author and respondents. Any actions related to investments and trading on crypto markets involve the risk of losing the invested funds. Based on the data provided, you make investment decisions in a balanced, responsible manner and at your own risk.

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