If the doors of perception were cleansed everything would appear to man as it is, infinite.
William Blake, The Marriage of Heaven and Hell
The Perception
There is a narrative (perception) out there that's gaining in popularity, which posits that the Fed is driving stock prices higher by providing what seems to be unlimited amounts of liquidity to the capital markets. But there's a problem with this narrative.
The Fed is buying bonds, not stocks. So how is this Fed liquidity finding its way into the stock market? I've been pondering this question for weeks, and I recently ran across an article that may offer some clues as to how it works. I'm looking for the transfer mechanism that moves Fed money from the bond market to the stock market.
I'll summarize the main points from the piece and add my own thoughts along the way. This is not a definitive answer to the question I posed in the title, but it has enough logic to at least merit consideration. I encourage you, dear reader, to share any thoughts you have, either in support of the article or in opposition. It's only through dialog that we can get close to what's really going on here.
The Article
Here is the original article by Jason Orestes of thestreet.com. In his article he makes several points about how the elusive transfer mechanism (from buying bonds to goosing the stock market) may work. I think his arguments are cogent and reasonable, but I leave it up to you to reach your own conclusions and share them with the rest of us.
His first point is "The stock market is not the economy, but the returns of indexes reflect a forward-looking lens into company earnings, which should be a reasonable proxy for economic activity."
I agree with this, but I have doubts about how quickly corporate profits will recover, especially since analysts are still in downgrade mode. They are lowering earnings expectations, and downgrading ratings as we speak. We haven't yet found the bottom of this part of the process.
His second point is "The Fed's quantitative easing (QE) program has been buying $625 billion of Treasuries in some weeks, an amount that exceeds what the Fed would buy over the course of eight months in prior bouts of QE.
It is also preparing to act on its plan to buy corporate bonds by way of The Secondary Market Corporate Credit Facility, and buying corporate bond ETFs in the open market, including junk bonds. Buying corporate bond ETFs is tantamount to buying every bond the ETF holds, which both provides liquidity and inflates prices. But this is all bond buying, and interest rates were already close to zero, so how is this inflating stock prices?"
Exactly. What's the transfer mechanism? He has some thoughts on that.
The Transfer Mechanism
He continues: "The Fed may not be explicitly buying equities, but its purchases have indirectly caused hundreds of billions to flow into them by pushing bond prices higher."
But how does that work, exactly? He has a theory, and it focuses on the ubiquitous 60-40 funds. These are Target Date Funds, State pension funds, Sovereign Wealth funds, and other very large asset managers.
"There were approximately $20 trillion in assets held by U.S. mutual funds at the start of 2020, and conservatively a quarter of that was in 60:40 mutual funds -- funds that must maintain portfolios of 60% equities and 40% bonds. These holdings are typically rebalanced the last week of each quarter."
Scale
"These mutual funds possessed about $3 trillion in equities and $2 trillion in bonds (a large portion of which are U.S. Treasuries) on Jan. 1, 2020. The fastest bear market in history then happened, and by March 23, the S&P index was down 31.3% year to date. U.S. Treasuries collectively were up 9% in that same span. The 60:40 ratio was now significantly out of whack, relegated to 48:52, or roughly $2.1:$2.2 trillion."
At this point in the article I'm beginning to think the author may be on to something. In order for the Fed money to move equity prices there must be significant scale. 60-40 funds are one place to find it. But is that enough scale to drive the entire stock market up 30% from the bottom? I'm still not convinced.
Then the author says "The majority of rebalancing began to occur the last week of March (also the time the stock market bottomed). This activity returned the 60:40 mutual fund ratio, or approximately a $2.55 trillion to $1.7 trillion split. This means a huge $500 billion of equity buying, and a commensurate amount of bond selling."
Well, o.k. $500 billion of equity purchases is definitely a big deal in terms of scale, but is it enough to drive the entire market higher by 30%? Again, I'm not convinced.
The author's final argument
"The S&P had a market capitalization of $19.32 trillion on March 23. The conservative calculation of $500 billion in Fed bond purchases being used for rebalancing would have accounted for 2.6% of the total index at that time, enough of a catalyst for the rapid, sustained rally we’ve seen since as the Fed hasn’t let its foot off the monetary pedal."
This is where I disagree with him. He argues that the effect of Fed bond buying on rebalancing to equities would have accounted for 2.6% of the total index. I'll grant that point. But when we look at the bond and stock markets in terms of daily trading volume, in dollar terms, we get a much smaller impact from the Fed activity.
The U.S. equity markets trade about $400 billion per day on average. The bond market about $600 billion per day. That's $1 trillion of daily trading activity on average. How far will $500 billion, or $2 trillion take a market of that mammoth scale?
To me, it just doesn't add up. The author makes some great points, but I'm left feeling unsatisfied that he has found the answer. What do you think?
I agree with you and Jason but I would add: the fed is supporting the bond market because it’s in bad shape and it’s worried about low (negative) rates. Because equities are low there are “bargains” in equities that also pay higher dividends. These 2 additional factors would help the argument. Assuming dividends and buy-backs start to lessen this connection would weaken.
But … the required scale you mention is not obvious to me. How about some rough numbers to look into this?
We have had infectious disease pandemics ever since the bubonic plague. They were quite frequent in the nineteenth century, and then we had the Spanish flu at the end of World War I, which actually occurred in three waves, with the second wave being the deadliest. Millions of people died. And we have had other serious outbreaks, such as the swine flu just a decade ago. So it’s amazing how unprepared countries were for something like this.
The coronavirus COVID-19 is spreading relentlessly through the world creating a path of death and destruction. The world is in danger of falling into a Great Depression, with millions of unemployed workers across the globe. The impact will especially hit the poor – both in terms of health and economics; many cannot even afford to wash their hands because of the lack of water. What will happen to the millions that cannot practice social distancing? The slum dwellers, the prison population, and the refugees huddled in tents?
Learning learning and again learning. If people have no idea how US central bank works they should not be in financial markets at all. People think that they understand banking system. Actually they don’t. What is M2 or MZM or why M3 was removed in 2006 or M6 is calculated !!!!! If You have no idea about , that means You have no idea about banking system and capitalism. I read thousands of books , it took me 15 years . Now with youtube help will take 2 hours . Links are below .
https://www.youtube.com/watch?v=WA1Ji-Hj1qo
https://www.youtube.com/watch?time_continue=135&v=S1qjswZdisM&feature=emb_logo
https://www.youtube.com/watch?v=X2F2Qg6m3Ic
https://www.youtube.com/watch?v=vhm3XXQqwmk
Good luck .
Andy