The US Stock market has been all over the place. Mr. Market becomes euphoric when any bad news is released, which isn’t “that bad”. Needless to say, the euphoria continues when there is any good news. With Federal Reserve’s “whatever it takes” attitude in place, speculators feel confident that the Federal Reserve will not allow asset prices to go down. In this week’s blog post, I’ll talk about the recent developments in the Fed’s policies, and the risk of inflation as a result of quantitative easing.
On Monday, June 15, 2020, the Federal Reserve announced that it will start buying individual companies’ corporate debt. This means that US is no longer going to be the survival of the fittest economy. The Federal Reserve can pick and choose the large companies that it wants to save. One of the Federal Reserve’s goal is to have maximum sustainable employment. This move of buying individual companies’ bonds would provide liquidity to those companies. Upon receiving this much needed cash (via issuing corporate bonds), those large companies are less likely to cut costs and lay off workers. So, by injecting liquidity into the large companies, the Federal Reserve is ensuring that maximum number of individuals stay employed.
This move by the Fed is definitely kicking the can down the road; The companies that are struggling will be financed by debt. That debt will be hard to pay back for many of these companies. You can relate this to your personal life. If you are struggling financially, and your credit card company comes in and says that it has increased your credit limit from $1000 to $30,000. This is great news because in the short term, you can survive. But, in the long run, even after you start generating income, it’ll be tough to pay back all that debt. Moreover, when we look at publicly traded companies, corporate bonds are senior to common stocks. So, when a company’s debt balloons, that company is going to have larger obligations to pay back that debt and interest accrued on it. This means that the common shareholder is going to be left with smaller piece of the earnings (if there is any leftover after paying back those senior security holders).
Looking at the graph below, the Federal Reserve’s balance sheet has expanded and contracted over time. During the 2007-08 financial crisis and subsequent recession, total assets increased significantly from $870 billion in August 2007 to $4.5 trillion in early 2015. Then, reflecting the balance sheet normalization program that took place between October 2017 and August 2019, total assets declined to under $3.8 trillion. Beginning in September 2019, total assets started to increase. As of the week of June 15, 2020, the Fed has injected about $7.1 trillion dollar into the economy. As you can see below, within a span of a few months, the Federal Reserve has injected more than $3 trillion dollars in the economy by buying assets.
According to the US Department of Treasury’s Treasury International Capital (TIC) report, foreign residents decreased their holdings of long-term U.S. securities in April; net sales were $150.2 billion. Net sales by private foreign investors were $104.9 billion, while net sales by foreign official institutions were $45.3 billion. This shows that, due to the near zero interest rates, investors are selling long term US securities, which increases the supply of USD. Basic supply-demand economics would show that when the Federal Reserve floods the market with Dollar, there is an increase in supply of dollar, which would lead to a drop in value of dollar (given that the demand for USD has dropped as foreign investors sell US securities). As the value of US dollar drops, US would notice inflation. In other words, your $10 is going to be worth a lot less tomorrow than it is today because the currency has lost value (buying power).
In order to make sure that the credit market doesn’t freeze up due to the COVID-19 economic lock-down, the Federal Reserve had to buy assets and inject the economy with USD. By buying corporate bonds and treasury securities, the Federal Reserve has provided more money to the already debt ridden entities. Moreover, the Federal Reserve has jeopardized the US banking system, and those banks start lending money to companies with poor credit ratings; As per this article, Fed’s Neel Kashkari warns bank losses during COVID-19 outbreak could trigger next financial crisis.
Ray Dalio, billionaire value investor, says, “When everybody thinks the same thing—such as what a sure bet the Nifty 50 is—it is almost certainly reflected in the price, and betting on it is probably going to be a mistake. I also learned that for every action (such as easy money and credit) there is a consequence (in this case, higher inflation) roughly proportionate to that action, which causes an approximate equal and opposite reaction (tightening of money and credit) and market reversals.” The Fed has injected trillions of dollars into the economy (action), so we are bound to see the “opposite reaction” to that at some point. Over time, as the Fed creates money out of thin air, inflation is bound to take hold. Given that the current US stock market is artificially propped up (fundamentals do not support the stock prices), I believe that the best hedge against inflation would be commodities. Precious metals such as gold and silver, or gold miners ETF (with low expense ratio such as GDX or RING) should appreciate if inflation takes hold and USD loses value.
In conclusion, as the saying goes, “To a man with a hammer, everything looks like a nail.” The Federal Reserve has already dropped the interest rates to near 0%. The only other tool that the Federal Reserve has is to print money. Printing trillions of dollars and buying assets (such as treasury bills and corporate debt) might temporarily fix the economic issue, but in the long run, this action is certainly going to have a consequence. Hence, the Federal Reserve has kicked the can down the road.
Hope you learned a little and found this blog post helpful. We talked about how the Federal Reserve is kicking the can down the road. It might be “solving” the economic problem right now, but is piling up a bigger problem ahead. As always, you can sign up for our free mailing list here. You can sign up for our paid subscription services here. Like us on our Facebook page here. Thank you!
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