A Rigged Stock Market: The Fed, Debt, & Buybacks | Part 1

“These markets are all rigged, and I don’t say that critically. I just say that factually.” ~ Ed Yardeni, President of Yardeni Research, Inc.

We start off with an introduction to the matter at hand by Dr. Robert P. Murphy an Associated Scholar with the Mises Institute, in his article The Fed Can’t Save Us he writes:

“Since the financial crisis of 2008, the stock market’s surges have coincided with rounds of QE, and the market has faltered whenever the expansion came to a temporary halt. The sharp sell-off in August 2015 occurred when investors thought the first rate hike was imminent (it had been scheduled for Sept 2015). That particular hike was postponed, but after it went into effect in December, we soon saw the market tank to 2014 levels.”

After the mortgage crisis in 2008, the Fed decided to intervene beyond it’s normal measures in order to stimulate the economy through buying longer-term US Treasuries and mortgaged backed securities (most of which are the bad loans made leading up to the crash) from commercial banks and other private financial institutions. This resulted in the raising of share prices (lowering yields) while simultaneously increasing the money supply (decreasing the value of your dollars). This was called “Quantitative Easing” (video is pretty funny). Through this action, the Fed has expanded its balance sheet from $850 billion to almost $4.5 trillion; and with each new QE injection, as Dr. Murphy pointed out, a stock market surge coincided. In other words, the rounds of QE are in large part, the lifeblood of the rise in valuation of the market.

In regards to the purchasing of US Treasuries and mortgaged-backed securities or QE (which the fed calls here “large-scale asset purchases”, the Federal Reserve states on their website:

“In conducting LSAPs, the Fed purchased longer-term securities issued by the U.S. government and longer-term securities issued or guaranteed by government-sponsored agencies such as Fannie Mae or Freddie Mac (insolvent companies). The Fed purchased the securities in the private market through a competitive process; the Fed does not purchase government securities directly from the U.S. Treasury. The Fed’s purchases reduced the available supply of securities in the market, leading to an increase in the prices of those securities and a reduction in their yields. Lower yields on mortgage-backed securities reduced mortgage rates as well. Moreover, private investors responded to lower yields on U.S. Treasury securities and agency-guaranteed mortgage-backed securities by seeking to acquire assets with higher yields–assets such as corporate bonds and other privately issued securities. Investors’ purchases raised the prices of those securities and reduced their yields.”

As you can see in the graph below, there has been a direct correlation between the “Federal Reserve’s Balance Sheet” and the performance of the S&P 500 Index (driving asset prices).

federal_reserve_balance_sheet_correlation_to_stock_market_sandp_500

Another way which the economy as a whole and the stock market can be manipulated is through the controlling of interest rates. Keep in mind, the term “interest rate” is another way of saying “how expensive it is to borrow”.

The “Federal Funds Rate”. Essentially is the interest rate used to determine what one bank can charge another overnight when lending them money from their reserves. As stated by the Federal Reserve Board:

“The federal funds rate is the central interest rate in the U.S. financial market. It influences other interest rates such as the prime rate, which is the rate banks charge their customers with higher credit ratings (for HELOCs, credit cards, auto loans, personal and commercial loans, etc.). Additionally, the federal funds rate indirectly influences longer-term interest rates such as mortgages, loans, and savings, all of which are very important to consumer wealth and confidence.”

sp_500_market_resurgence_and_federal_reserve_intervention

As you can see in the graph, along with the Federal Funds Rate, the 10 year yield on US Treasuries have also been in a correlated decline. Reason being, as the Fed sets its target for the federal funds rate, it will then buy (or sell) US Treasury securities (part of its normal market operations) until the rate is reached, and continue to buy (or sell) in order to maintain that target. As the Fed buys more Treasuries, the interest rates on them go down and the price on them goes up. This is economics 101 of “supply and demand”. And the purpose of all this is to increase the excess reserves the banks hold and lower interest rates, which enables them to lend out more money. At least theoretically.

Although it is cheaper to borrow, if you take a look at the chart below, you will notice that banks have actually decided NOT to lend out the majority of those excess reserves as the Fed intended (or designed) and instead are holding onto the additional $2.2 trillion at their local district federal reserve bank earning 0.50% (which was never done before 2008). To put that into perspective, the highest amount the banks held as excessive reserves between 1959 and 2007 was $19 billion (it’s the little dot in the recession graded area in 2001).

excess_reserves_held_by_the_federal_reserve_banks

How does this all affect you?

  • It directly affects the returns offered on bank deposit products like, savings accounts, cd’s, and money market accounts. In other words, safe places where you can store your money. The lower the fed funds rate, the less attractive “savings” are, forcing you to either speculate in riskier investments (so you can keep pace with the devaluing dollar), or spend it on consumer products that hold no real value. Or as Investopedia puts it:

Investors have a wide variety of investment options. When comparing the average dividend yield on a blue-chip stock to the interest rate on a certificate of deposit (CD) or the yield on a U.S. Treasury bond (T-bonds), investors will often choose the option that provides the highest rate of return. The current federal funds rate tends to determine how investors will invest their money, as the returns on both CDs and T-bonds are affected by this rate.

  • It shows that the growth in the market has been mostly due to monetary policy of the Federal Reserve and their “large-scale asset purchases”.
  • The huge amounts of excess reserves pose a heightening risk of hyper-inflation. For they can roughly create an additional $20 trillion (per fractional reserve lending) on top of the current M1 money supply (money in circulation and held in checking accounts).
  • In addition to the reduced incentive to save, the lower interest rates make the cost of borrowing cheaper. This encourages corporations and households to take out loans (debt) to finance further spending and investments. As both of these rates decline, there is an inverse correlation to the rise of stock prices. Why? Well as it becomes cheaper to borrow, corporations and speculators in turn start buying on margin and binge on buybacks.

Part 2…

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