Central Bank Largesse Fuels Global Stock Market Rally

by The Curmudgeon

During the last four years, the Federal Reserve has been actively supporting the U.S. stock market by suppressing interest rates to historically low levels, while injecting liquidity into the financial system through a variety of different programs.  The most notable program is Quantitative Easing (QE), which involves the outright purchases of long term Treasury bonds and Mortgage backed securities by the Fed.  "Operation Twist," officially called the "Maturity Extension Program," is when the Fed sells Treasury bills and other short term securities to buy longer dated Treasuries and Mortgages.

Currently, the Fed is purchasing $85 billion of fixed income securities every month, attempting to stoke the economic recovery and lower unemployment. The central bank began $40 billion in monthly purchases of mortgage-backed securities in September and added $45 billion in Treasury securities to that pace this month.

It's incredible to the CURMUDGEON that these programs have gotten larger, even though the U.S. is in its fourth year of "economic recovery" with interest rates at zero for all that time!


Quantitative Easing or QE used to be called "debt monetization." It has the net effect of creating money- currently $85 billion a month- "out of thin air."  The Fed’s total assets climbed by $48 billion in the past week to a record $3.01 trillion as of Jan. 23, 2013, according to a press release from the U.S. central bank.

The Fed may be starting to realize the risks of an ever expanding, bloated balance sheet.  One risk from a large balance sheet is the possibility that the Fed’s interest income could evaporate in coming years as interest rates rise, according to a paper written by Fed researchers and released last week.

Another risk of QE and the resultant increase in the Fed's balance sheet is that in a rising rate environment (which always comes with real economic growth), the Fed might be forced to sell the long term Treasury and mortgage securities it purchased at a huge loss.  That could significantly increase the U.S. national debt, which is already a huge financial burden and a contentious issue for the U.S. Congress.  When rates rise, interest payments on the U.S. national debt will be a very real problem.

"We’re in uncharted territory,” said Julia Coronado, chief economist for North America at BNP Paribas SA in New York city and a former Fed economist. Even as “the easy money will flow through financial markets and into the real economy at some point and lift us to a better growth trajectory,” the U.S. faces “a lot of risks,” she said.

“You’re hard pressed to find another example in history where the Fed pulled out all the stops to help a recovery along,” said Michael Hanson, senior U.S. economist at Bank of America Corp. in New York, and a former Fed economist. “It’s at least as revolutionary as Paul Volcker coming in and saying we’re going to hike rates until inflation declines.”


With economic growth significantly below the 3% long term trend rate and corporations hoarding cash, (rather than investing in plant, equipment or hiring more employees/contractors), little of the money the Fed has created is having a significant impact on GDP.  In an earlier post -- we wrote "Corporations are using their profits to mostly hoard cash, buyback shares, or (in some cases) increase dividends on their common stock."  Hence, most of the money the Fed is creating is NOT going into the real economy!


Instead, the new money that the Fed has created is going into "risk assets” like global equities, junk bonds and emerging market debt. Here's a look at timing of the various Fed QE programs and the stock market rises at that time:

This year's rising stock market has pulled investors off the sidelines and into the equities as witnessed by near record cash inflows to equity mutual funds/ETFs, overly bullish investor sentiment, and extreme complacency - as measured by extremely low levels of market volatility (the VIX).  Money is being taken out of safe haven investments, like U.S. dollar denominated cash, Swiss Francs and Treasury bonds, and placed into much riskier assets like the one's we've mentioned above.

"Americans seem to be falling in love with stocks again," says the lead story from today's NY Times:  As Worries Ebb, Small Investors Propel Markets


The article states that individual investors are now pouring more money than they have in years into stock mutual funds.  And this comes after a four year run up in which the major market averages have doubled and are approaching their all-time highs.



It's a Global Affair


Of course, other central banks (e.g. ECB, Japan, UK, etc.) are also keeping short term rates artificially low and buying sovereign government debt, but not on the scale of the U.S. Federal Reserve.

The European Central Bank (ECB) will keep in place its option of buying government bonds even though the risk of renewed pressure on the euro is easing, the bank‘s president Mario Draghi said Friday at the World Economic Forum.

"The Bank of England has purchased 50% of the gilts issued since 2009 and owns 32% of the whole gilt issuance currently in existence," wrote Clive Hale.


Commenting on the decoupling of Apple's stock price decline from the overall stock market rise this year, PIMCO’s co-CEO Mohamed El-Erian said it was all due to central banks' willingness and ability to continue to artificially support financial markets. "The greater central banks' effectiveness in raising asset prices and delivering economic outcomes, the more likely that markets as a whole will escape negative contagion from Apple,” he said.


Interestingly, PIMCO's other co-CEO (Bill Gross) said on a conference call last week that his firm expected only a 5% total return from global equities in 2013, with bonds returning only 3% in 2013.  The entire year's equity return might be realized in January of this year!





What's so surprising is that the Fed hasn't learned its lesson of creating and feeding the two previous bubbles that popped- the dot com stock market boom and then the real estate bust.  But then it was only keeping interest rates artificially low.  Now it is also injecting billions of $s each month into the banking system which finds its way into financial assets rather than the real economy.  The biggest risk of these QE programs and artificially low interest rates is to turn savers into speculators and create yet another bubble in risky assets, which will surely burst causing another severe recession (or worse).







Until next time...........................................


The Curmudgeon

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.