The Fed Is Going To Buy Stocks

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The Fed is going to buy stocks. I don’t know precisely when (sorry day traders), but it will happen, and probably soon.

The first half of the Fed’s dual mandate is to promote maximum employment — that means avoiding and mitigating recessions. Supporting the S&P 500 is central to this effort, not because a fall in the market signals a recession is coming, but because it is the recession. This isn’t what we’re taught in Economics 101 and frankly it isn’t how most economists understand the market, so the idea requires a little backstory.

The Rise of Carry

The S&P 500 drives the economy through its central role in the global carry trade. Carry traders earn a yield spread, or an up-front premium payment, as compensation for the risk that the asset they’ve purchased will depreciate or the event they’ve insured against will occur. These transactions, and a wide variety others like them, are “short volatility”. They do well when the world stays the same but can crash suddenly when things change.

Carry trades always increase both leverage and liquidity. The growth in leverage makes the world more fragile, but increased liquidity temporarily hides this fragility. Debt financed stock buybacks are an important example. Their growth reinforces the leveraging up of corporate balance sheets (increased fragility) and at the same time provides a critical source of equity buying (increased liquidity) for those investors who wish to raise cash. We shouldn’t underestimate this dynamic — for over a decade now the only sector that has consistently purchased US equities has been non-financial corporations.

The price of this liquidity provision is proxied by the stock market’s volatility — the VIX. When it skyrockets in a crash — as it did in March — carry trades lose money, carry traders withdraw from their positions and liquidity evaporates. In a leveraged and liquidity dependent world, a fall in the US stocks and a rise in the VIX, has immediate negative consequences for the economy, forcing the Fed to act.

In 2008, and again in 2020, the Fed was able to support the S&P 500 indirectly by lowering rates, purchasing government debt and making loans to buy risky bonds. With each intervention they’ve crept closer to buying stocks. This is no accident. When the Fed intervenes to support markets, it suppresses volatility and truncates losses for carry trades. This in turn encourages them to grow in size and scope, thus almost automatically guaranteeing that the next round of support will need to be larger. The most recent round stopped just short of buying equities, the next round will take Fed over the threshold.

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Source: Kevin Coldiron | Forbes

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