“Don’t Fight The Fed”!
This was arguably the most successful investment strategy over the past ten years. There was also no easier way to tarnish one’s reputation and career than to ignore this profitable slogan, as many respectable money managers learned. However, given my assessment of the economic landscape and understanding of the bank’s inner workings, I find myself questioning the success this strategy might have on a prospective basis.
To fight the Fed or not? I explore this very question in The Librarium Associates’ latest “Around The World In 8 Pages …” quarterly report. It also contains several other thought-provoking articles covering the global investing landscape. My contribution begins on page 7, below.
Seth, I have read all your blogs on how central banks work including this one. First of all, I would like to thank you for writing such wonderful articles explaining how the system works. You have expanded my knowledge greatly and for that, I can’t thank you enough. I have few questions that I would like some clarification and I’m hoping you can answer them. So we all know that the bull market is due to corporate stock buybacks. When the Fed increased the banking system excess reserves, did any of the excess reserves ended up as loans to corporations so they can buy their shares? If not, and companies issued debt instruments to do these activities where did all that capital come from to support all the share buybacks? Also from a return on capital point of view wouldn’t it be better for corporations to invest money in actual economic activity and capex to increase their cash flow and deliver better returns to their shareholders as opposed to share buybacks? Second question, so the Fed buys only from primary dealers who are well known financial entities like Goldman, JP Morgan, RBC Capital, etc. The dealers have an extensive range of financial businesses besides your loans to private companies business such as the trading desks, hedge funds, derivatives, high yield debt etc. The eligible dealers are encouraged to submit offers for their stock of treasuries and their clients stock of treasuries to the FED. Those customers can include the very wealthy investors, Hedge funds, Pensions funds, Sovereign funds, Investment banks etc. So when the FED buys the government bonds from both the primary dealers and their customers through them, they credit the accounts of the primary dealers and the primary dealers also credit the account for their customers. Since those dealers and their clients want to make a profit they will not sit on that cash. So some of that cash will flow into the financial markets especially from the customers of the dealers since they are into the business of investing into the financial markets. They have to put the dollars generated from the sale of the treasury bonds into work by investing in riskier assets. The dealers will also put the cash to work not necessarily into the real economy but into the other lines of businesses they have such as the trading desks, therefore that money ends up into the financial markets, and hence this enormous price inflation of risky assets. So Is there a correlation between QE and asset price inflation? But the data shows that corporate buybacks have a bigger impact than QE? When the FED engaged in QE through the primary dealers where shadow banks are allowed to participate indirectly, did some of that money ended up as loans to corporates to buy back their stock? Can you please reconcile this one for me? Why does the FED allow the shadow banking system to participate indirectly in these transactions? I thought their mandate was only to increase excess reserves of banks and only banks?
Hello Wissam,
Thanks for your kind words. I’m glad you’ve enjoyed my articles. On to your questions … I’ll do my best:
1) Excess reserves are just that – reserves that primary dealers hold at the Fed. Banks earn IOER on them and they also help satisfy regulatory liquidity requirements. By definition, these are funds held against loans in excess of the statutory rate, hence they are not loans themselves. Corporate buybacks largely are funded in the public corporate bond market (i.e. buy investors). I’m sure banks played a part, but it’s hard to say how much, and I would guess a small one. Whether or not companies would have been better off spending on capex rather than buy backs really comes down to the individual company’s business prospects. While it’s hard to argue that buying back stock at all time high equity valuations is accretive, I think it’s wrong to apply such blanket statements to all companies as many do. Perhaps some had no better use of funds making it proper to return them to their owners.
2) I think it’s a fair to assume that BOTH QE and corporate buybacks had an inflationary impact on asset valuations. They simply represent incremental demand for marketable securities (for USTs & MBS in the case of QE, and for stocks in the case of buybacks). How much of an impact is highly debatable (and likely unknowable).
Whether or not QE caused higher levels of stock buybacks is complicated. I think companies have been buying back so much stock because economic growth has been paltry. Here, I think QE is more the symptom of a larger and structural issues rather than the cause. The prescription for slow growth is, in my opinion, more economic freedom and political stability. This includes the currency as well. It’s fair to say that since the GFC both have eroded.
Lastly, the Fed has no control over the shadow banking system (thank heavens!). In fact the shadow banking system evolved to circumvent it. While this system certainly has its (big) faults, it is my belief that the “eurodollar” system created a significantly more flexible financial system that a dynamic global economy requires, and helped fuel economic prosperity. In fact, if we didn’t have the Fed (and other central banks) it wouldn’t be in the shadows at all; it’d be out in the open for all of us to observe. Relegated to the shadows, some bad practices developed (both innocent and not) and we’re still paying that price.
I hope that helps.
Seth