Amongst the many responses to my last post “When MMT Meets The S&P” , the best and most important one I received was this question: “What is the mechanism by which the Fed is indirectly supporting equity markets? Since they haven’t yet announced the direct purchase of equities, how is their trillion dollar underwriting affecting this rally?” (From fellow ultrarunner and Guinness World Records holder Chris Solarz of Cliffwater who has done seven full triathlons in seven days, amongst other amazing world records.)
The simple answer: Financial Engineering. There are three ways I will discuss here how the Fed is supporting equity markets without announcing or undertaking the direct purchase of any stocks.
Direct support of corporate bonds: With the Fed’s balance sheet expanded to almost $8 trillion, and new facilities in place to buy primary and secondary market corporate bond purchases, the Fed has engineered a truly levered purchase of equities. This is because of the relationship between the debt and equity of a company, which financial analysts know as the “Merton Model” of a firm’s capital structure.
When the Fed buys corporate bonds of a company, it compresses bond spreads and volatility, which simply means that the implicit value of the equity of each company goes up. This is because tighter spreads mean lower default probabilities, which is equivalent to a higher expected value of the firm’s equity (lower default probability means that there is lower likelihood of equity holders getting wiped out). Note that as of the end of June the Fed was the second largest owner of the Vanguard Short-Term Corporate Bond ETF (VCSH), holding 4.53% of the outstanding shares, and the third largest owner of Blackrock’s iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) holding 3% of the outstanding shares (Source: Bloomberg). By buying these billions of dollars of ETFs, the Fed essentially used the relationship of corporate bonds and corporate equities to boost the equity prices of the companies without even buying a single share. Details of exact amounts of ETFs purchased are posted on the Federal Reserve’s website (here).
In the picture below (taken from Bloomberg data on July 1, 2020) we see that the total number of outstanding shares in these ETFs has jumped along with the increase in the Fed’s balance sheet and with its outright purchases of the ETFs. Especially for LQD, shares outstanding have jumped from 250 million shares to over 400 million shares over this period. (Source: Bloomberg). If I were to overlay the increase in the Fed’s balance sheet on this increase in the share count, the correlation would be extremely high.
So why does the Fed purchase of ETF shares not show up in the ETFs trading at a premium to their NAV (Net Asset Value)? If the Fed is buying corporate ETFs, won’t they richen up the ETF relative to its underlying holdings? In fact, the Fed’s Secondary Market Corporate Credit Facility writeup on its website (here) says that they would not buy ETFs if the prices materially exceed the net asset value of the underlying portfolio:
“Pricing: The Facility will purchase eligible individual corporate bonds and eligible broad market index bonds at fair market value in the secondary market. The Facility will avoid purchasing shares of eligible ETFs when they trade at prices that materially exceed the estimated net asset value of the underlying portfolio” (author’s underlines).
In other words, what the Fed is saying is that it will only buy ETFs as long as they are fairly priced; i.e. the weighted average value of the underlying bonds is close to the value of the ETFs. Obviously one reason for this disclaimer is to put to rest critics who say that the Fed is distorting the ETF market. But can we really say that ETF prices are not distorted by simply looking at the premium of the ETF to its NAV?
Unfortunately, the Fed — and indirectly the tax-payer — might have allowed itself to be gamed by savvy market professionals, yet again.
To see this one has to understand how ETFs are created. In short, when the Fed purchases ETF shares, so called “authorized participants” can create new shares if they don’t have the ETF shares already. In other words, when, the Fed indicates to the creator of the ETFs (e.g. Blackrock or Vanguard in these examples), that it intends to buy ETF shares, the Fed can either buy the underlying bonds and deliver them to the ETF creator in exchange for the newly created shares, or let the creator of the ETF go and buy the bonds in the open market to create the ETF basket. So there is plenty of potential for what is called “front-running”. As soon as the Fed published their criteria of eligible ETFs, market makers and arbitrageurs got the cue and probably bought these bonds ready to deliver to the Fed when it came for the ETFs. One could label this a classic case of wealth transfer from the taxpayer to the market makers and arbitrageurs in the name of “supporting the market, uh… the economy”. The reason the ETF is not trading at a premium is because the ETF creator packages the ETFs into a basket and sells the basket (the ETF) to the Fed’s facility. But this does not change the fact that the underlying bonds themselves are more expensive than they would have been without Fed buying, and by extension, the equity of these issuers is richer than it would have otherwise been.
Volatility suppression: The second mechanism by which the Fed is indirectly supporting equities without having to explicitly buy them is what can now be called the “Powell Put”. The market now believes the promise that the Fed will be there to support the equity markets as needed, so the Fed can be thought of as an equity market insurer of last resort. By underwriting this put, the Fed is basically funneling tax-payer credit into the market since selling a put theoretically is equivalent to selling volatility and being long the stock market. Further, since the Fed has a printing press, it has an infinite ability, at least theoretically, to support the equity markets, as long as the taxpayers allow it to do so. This unlimited volatility selling promise has resulted in a cratering VIX (it fell from 80 to below 30; Source: Bloomberg), and when volatility falls, risk-based systems increase allocation to equities in another version of financial engineering-driven portfolio construction. So by moving the tail (VIX) down, they are able to move equity markets up and tighten credit spreads further (see above for how tight credit spreads boost the stock market).
Discount rate manipulation: The Fed has three traditional and two more novel levers that it is using when it comes to interest rates. First it cut short rates to zero. Second, it started the latest round of QE to buy long term assets. Third, it is using forward guidance or expectations management to keep long term yields from rising. A fourth strategy, called yield curve control is under consideration, which would “twist” the yield curve with longer term yields falling more than shorter term yields. And finally, there is the potential of a fifth strategy, of negative interest rates, which the Fed is denying so far as a possibility, but in my view is inevitable. Indeed, using my own calculations of the now largely defunct “Taylor” rule, one would expect the equilibrium Fed Funds rate to be close to minus 5%! Since 0% is so far away from minus 5%, we should believe the Fed when it says its “not even thinking about thinking about raising rates”. Thus, all else being equal, for any model of equity pricing, such as the traditional DCF (discounted cash flow) model, any of these five factors that lower rates would result in higher current equity prices. This is not my forecast, it is simply financial engineering mathematics.
The above three mechanisms are examples of the use of financial engineering, in a highly levered manner, to indirectly influence equity prices. Each of these mechanisms also has a potent psychological element associated with it as well which turbocharges equity prices by influencing investor behavior. Whether the Fed buys corporate bonds or ETFs, suppresses volatility, or reduces rates, the common impact is that the investing public feels less risk averse and more likely to suffer from bouts of FOMO (Fear of Missing Out), and TINA (There is No Other Alternative) and rides on the Fed’s coattails to create MAMU (Mother of All Meltups – thanks to Ed Yardeni for the last acronym). The financial engineering outcomes are thus levered up because of the psychological impact of animal spirits adding to the bullish sentiment. And with MMT all the rage, the main beneficiaries of unlimited money printing and credit extension are stock prices.
Alas, as we know, even financial engineering has it limits. If we dig deeply all three of these modes can fail if the transmission mechanism, i.e. “financially engineered leverage” fails. And financially engineered leverage can fail suddenly and sharply.
For instance, if corporations issue ever more debt to meet the Fed’s demand for corporate bonds such that corporate leverage rises faster than the actual capital available to support it, the first mode fails. If the Fed fails to make investors whole the next time the equity markets fall, (i.e. it fails to honor the implicit put option it has written) the market’s belief changes. Finally, if there is true inflation and the bond market falls sharply due to rising yields, then the discounted cash flow mode of boosting stock prices fails. If all three fail simultaneously, things could become dire indeed.
In that low probability but extremely high severity scenario the Fed would likely just buy equity ETFs and equities. As long as the Fed has the authority to buy assets, print money, and under-write risk taking, as it currently has, don’t fight the Fed. But be ready to bail out as soon as they start thinking about thinking about raising rates.
Shares Outstanding in Corporate Bond ETFS LQD and VCSH. Source: Bloomberg.
VINEER BHANSALI