Let’s take a look at the stock market since the Fed ended Operation Twist at the end of 2012 (where they were alternating short-dated bond sales and long-dated bond purchases every few days), and transitioned solely to purchases of bonds (in the amount of $85 billion per month).
S&P 500 ETF (SPY ) – 9 months
Do you see how the market has gone from back and forth chop to a straight-line higher? That’s what happens when you slowly hand banks and financial institutions on average $4 billion per day. A lot of it sitting as capital reserves, but a good chunk is being put to work as a slow drip into the best performing asset: stocks. If you would like to see the Fed’s past schedule of operations, you can find it here. They’re also publishing they’re future purchases each month, which I’m sure traders are trying to front-run at this point. It’s a snowball effect.
You may be wondering where the Fed gets $85 billion every month to purchase bonds…
Here’s the process:
- The US Treasury needs money to finance our government’s deficit so they sell bonds to the world/market
- The Federal Reserve needs money to buy Treasury bonds on the open market so the Treasury prints $85 billion per month of cash and hands it to the Fed
- The Fed uses this $85 billion to buy the very same bonds the Treasury issued
- The Treasury pays interest on the bonds to the Fed
- The Fed turns around and hands the interest earned back to the Treasury at the end of every year
(It’s important to note that this is theoretically what would happen. The printing of physical dollars does not actually happen (it’s all electronic) and the Fed has the ability to “print” money at will on its own. But the Fed is returning interest payments to the Treasury as a refund for taxpayers.)
Where things get interesting is when we look at the government’s annual deficit. The US Government is running an annual deficit around $1 trillion. The Federal Reserve is conveniently buying $85 billion/month of US Treasury Notes/Bonds and Mortgage-Backed Bonds. Simple math tells us: $85 billion x 12 months = $1.02 trillion! How convenient! The Fed is now funding our annual borrowing needs by printing money at a net cost of 0% interest to the government/taxpayers. Sounds too good to be true, doesn’t it?
Essentially, Ben Bernanke is taking a gamble that he can temporarily manipulate and leverage the money supply and interest rates to jumpstart the economy. In the short-term it has been working but we have a long way to go. Here are the bigger concerns:
- Is the Fed yet again fueling another bubble? The stock market is being driven higher at a rate faster than economic improvement. Things have been slowly improving but not like this stock market activity is indicating.
- What will happen if the Fed is forced to end QE earlier than they desire and sell bonds at a loss?
- What will happen if the economy begins to slip again for unforeseen reasons? This could be from political or international factors, or simply a lack of confidence in the economy. How long can this game continue? (probably a lot longer than anyone thinks)
I’ve been saying since the start of year that US stock prices are outpacing the improvement in fundamentals. If the fundamentals don’t start to catch up, this story will not end well. US Stocks are being driven into over-valued territory by the Fed as they push investors seeking higher yields into riskier assets. I hope the fundamentals do catch up, but the risks are building if they do not. I’ll continue riding it higher, but the higher we climb, the more I’m going to hedge.
The unfortunate thing is that it’s just now sucking in the people that sold in the spring of 2009 and have been waiting on the sidelines for a “good time to buy back in”…which is after the market more than doubles off the lows and makes all-time highs?
I’ve actually been picking up US Government Treasuries which should be a shock to anyone that has been with me the past few years. I had been a big hater of Treasury Bonds! And it worked well considering just about every other asset outperformed them to this point. It always comes back to value though, and relative to other assets on an expected risk/return basis, I think the 10-year Treasury right here, north of 2%, offers decent value.
Nick