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How and why stock prices are rigged by the Fed

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Summary: 

  • -Elevated stock prices are key to the solvency of pensions, insurers, banks, and retirement funds 

  • -Markets are political: in lieu off strong core growth, both Obama and Trump have explicitly touted stock index prices as signs of economic prowess

  • -The tail wags the dog as the stock market is now the wealth effect generating indicator that drives consumption 

  • -Monetary and fiscal policy has been important to upholding current stock valuations

  • -Unprecedented stimulus is being prepared as central bankers demand stronger than ever post-crisis tools 

 

The Importance of Elevated Stock Prices for Financial Vehicle Solvency 

  • -Pension plans are highly vulnerable to a bear market in stocks. Over 50% of current pension allocation is in equities, up almost 5% from 2017. State pension funds are even more vulnerable with over 65% equity allocation on average

  • -Too big to fail banks are larger than ever and vulnerable to the type of >50% equity decline seen twice in the last 2 decades. The top 10 banks own more than 50% of the assets of all the combined top 100 banks

  • -Retirements are vulnerable as well, with 52% of Americans at risk of falling short even at present equity valuations

 

Stock Markets are Political 

 

Core economic and domestic growth is the lowest it has been in decades as secular stagnation has set in, as I chronicled here. Since the deficit fueled growth and inflation of the Bush era has come to a halt, low inflation and stagnant wages have been the norm over the past 10 years.

 

With the economy as the number one issue for Americans in 2008 and underlying President Obama’s election, and no solid core growth to report, Obama repeatedly used skyrocketing stock valuations as a barometer of his own performance, making continued reference to them in speeches as well as his 2011, 2012, 2013, 2014, 2015, and 2016 SOTU addresses. 

 

While Trump originally criticized Obama’s stock market performance, calling it a “big fat ugly bubble” fueled by an accommodating Federal Reserve, he has since become a frequent cheerleader of stock valuations, invoking them repeatedly ahead of the upcoming midterms. 

 

 

Because of continued reference by Obama and Trump to stock prices as an indicator of economic well-being, Americans have now internalized the idea that they reflect the true performance of the economy. This means that not only is it important in the public eye for each president and ruling party to have higher stock valuations than previous ones, but presidents and parties who fail to accelerate the appreciation of stocks will be criticized. It also means that leading politicians who fail to keep stock prices high through stimulus will take the blame for the collapse of the financial vehicles mentioned above.

 

 

Stock Appreciation as a Wealth Effect. Potential Depreciation as an Undesirable Reverse Wealth Effect 

 

In the current market cycle from 2008-present, savings were highest during the immediate aftermath of the crisis and years following, declining ever since 2012 as the market generated high returns. This decline in the savings rate signals that people have been more willing to spend as stocks have risen, even though returns from savings accounts have become more robust. 

 

The stock bull market, generally understood to be a derivative of core economic growth and consumption levels, has actually evolved into a signal that everyone is following. Appreciating stock values have become a sign that the economy is healthy and it is safe to spend. We are also told this over and over by politicians and pundits. Depreciating stock values on the other hand are a sign that the economy is unhealthy and that it is not safe to spend. 

 

Stock market signaling is now an independent catalyst or inhibitor of consumption 

 

One interesting study that dovetails with these suspicions is a study from 2014 which shows evidence of a stock price based wealth effect in developed and market based countries but not in places with less financial development. In other words: more financialized countries with slower growth care about stock prices and internalize them as a signal for consumption. 

 

A reversal of stock price appreciation then, is extremely undesirable for financial accounts and for presiding politicians. Not only could it push households and institutions to the brink of insolvency, but stock price reversal could decrease PCE levels independent of the overall cycle and create a downward spiral for consumer and asset prices. 

 

Falling consumption levels as a result of stock depreciation are dangerous because the economy has been veering ever closer to deflation as a result of macro level changes in the working age populace which I discussed here. Deflationary or disinflationary effects can loop back and effect stock prices too through reduced earnings and increasing real costs of debt. 

 

Monetary and Fiscal Stimulus Have Been the Key Drivers of Appreciation of Stock Prices 

 

The main tends that have caused stock prices to explode since the 1980s (beginning of the financialization era) have been interest rate suppression and an exponential increase in government spending. 

 

 

Interest rate cuts increase spending by making it marginally less desirable to save money in a now lower yielding bank account, by lowering the cost associated with borrowing money to spend, and by making investments more affordable. The low interest rate economy has cut savings rates from 12% in 1980 to 6% today. The massive expansion in federal spending has kept demand and corresponding earnings artificially high. The result of this stimulus on the price of the stock market? Below 

 

 

 

When the 2008 stock market crash occurred and there was net deflation for the first time in over 50 years, central banks took a new step and decided that deficit spending and rate cuts were not enough. Quantitative easing was established through which the Fed printed money to buy bonds and push down long term interest rates. Not only were rates cut to 0% and federal spending increased, but now the Fed’s balance sheet exploded, laden with trillions of dollars in bonds. 

 

 

 

When Low Rates and Spending Aren’t Enough: The Future of Stock Price Stimulus 

 

Despite the success of fiscal and monetary stimulus in raising stock price valuations, these have not been enough as QE has been applied as well and more methods of stock price manipulation are likely coming down the pipe. Recently there has been a lot of chatter in a short period of time among central bankers surrounding the potential for the Fed and other central banks to buy stocks. As opposed to merely manipulating other factors such as interest rates which raise them by proxy, the Fed would use its trading desk and create money which it would use to buy stocks in a crisis. It is also worth nothing that the BoJ and SNB already buy stocks.

 

9/4/18: JPMorgan Chase sends a report to its clients which includes this statement from a senior analyst: “It remains to be seen how governments and central banks will respond in the scenario of a great liquidity crisis. If the standard interest rate cutting and bond purchases do not suffice, central banks may more explicitly target asset prices (e.g., equities). This may be controversial in light of the potential impact of central bank actions in driving inequality between asset owners and labor.”

 

9/8/18: At the 62nd Federal Open Market Committee conference, former Chief Economist of the IMF Olivier Blanchard endorses the Fed buying stocks, saying that the Fed could double its balance sheet to include stocks and, “nothing terrible would happen.” He says that buying stocks would, “do the trick and could work even better than buying long bonds.” 

 

9/9/18: Two former treasury secretaries and a former Fed chair Tim Geithner, Hank Paulson, and Ben Bernanke write an op ed for NYT calling for the Fed to have greater leeway in operations and decrying regulations such as Section 1101 of Dodd Frank which prevented the Fed secretly loaning to insolvent banks. 

 

10/11/18: The Economist posts an op-ed arguing that countries like Japan offer prime examples of what solutions central banks have when dealing with asset price declines. One excerpt reads: ”Central banks could undertake this in places where they are authorised to buy equities or equity funds. An alternative would be to establish a sovereign wealth fund with the resources to buy and sell securities in order to stabilise wobbly markets: to unload shares when investors turn exuberant and buy in times of despair.”

 

As far as the promise to eventually offload stocks, don’t buy it. The Fed promised the same with QE that bonds would eventually come off the balance sheet. There are still over $4,000,000,000,000 worth of bonds yet to be sold and with 2/3 of economists predicting a recession before 2020, it is more likely to be growing than shrinking in due time. 

 

While it could be argued that the stock market’s role as a field to price capital has already been subverted by overly active central bank policy, moving to buy stocks would be an unprecedented step toward stock prices becoming not as much prices reflective of intrinsic value but rather ever rising guarantors of retirements and bank solvency. 

 

Conclusion:

 

Stock prices are too big to fail. They are the backbone of retirements, powerful banks, and pensions. They also underpin the personal wealth of the people who make decisions surrounding fiscal and monetary policy and their collapse would imperil the real economy as well. As if the personal wealth of policymakers and bankers weren’t enough to incentivize them to increase stock prices, the political fallout of allowing them to collapse is too large to even consider. 

 

 



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