What I'm Watching - The Fed Impacts Everything

Once again I find my attention drawn to the Federal Reserve and the impact of this greatest monetary experiment in history. Back in the late 1970s, while majoring in economics at Stanford, I took a quarter of directed learning with a professor on the topic of “Money and Banking”. I’m not sure exactly why, at age 21, I found the topic interesting enough to pursue in depth. Maybe it was the unprecedented high interest rates of 20% in the early days of Paul Volcker’s tenure as chairman of the fed. Or, perhaps it was after attending a lecture by the late, great Milton Friedman. In any event, since then I continue to follow the doings of the Fed and actually find it interesting. I know, a bit geeky but aren’t financial planners supposed to be geeky?

Seriously, I believe the jury is still out on the ultimate wisdom of employing such untried methods to spur the economy. There just have to be unintended consequences, collateral damage if you will, in this war against deflation and economic stagnation. Lately, I’ve been trying to step back and see a bigger picture and one issue keeps jumping out. Are certain market actors immune to prices they pay for the securities they buy? Specifically, I wonder if prices matter when the fed is implementing policy. Fed policy has actually triggered two classes of stock “investors” to purchase stocks seemingly regardless of price as well. How might this all play out?

Who Is Buying and Why?

Does It Matter if the Fed Loses Money?

Sorry if I’m beginning to sound like a broken record, but I keep coming back to the Federal Reserve’s quantitative easing program which is being copied around the world by other central banks. Many, many words have been written in analysis and commentary and I don’t want to pile on much more than I already have so I’ll try to keep this brief.

Over the past six years, the Fed has purchased over $4 trillion in bonds to force down interest rates. They have succeeded in driving rates to some of the lowest levels in history and bond prices to the highest levels in history. What I’m wondering is whether it matters that the biggest bond buyer in the history of our country is paying some of the highest prices in history. I know when we investors overpay for our investments, it usually comes back to bite us and ends with painful losses. The Fed’s motivation in purchasing these bonds, many paying less than 1%, is not because they are cheap but to implement economic policy.

My concern/question is what happens when rates go up? And, they will go up eventually! We know the prices of their bond holdings will decline. Depending how high rates go up, I wouldn’t be surprised if they end up sitting on the greatest losses of any “investor” in U.S. assets in history. Theoretically, they could just hold the bonds until maturity. If they don’t sell, does it matter? Truthfully, I can’t quite figure it out and smarter people than I can probably explain why it doesn’t matter. Yet I’m not so sure. With higher rates, the value of their assets (the bonds) will be worth less while their liabilities (bank deposits, currency …) won’t necessarily decline. If that was the case for me, I would probably end up insolvent and heading to bankruptcy court.

A possibly worse scenario would be if inflation becomes a problem forcing them to again implement policy but this time by selling these bonds at huge losses to drain the system and shrink the money supply. These losses might end up increasing our budget deficits, perhaps significantly.

So far, it has all been good with no noticeable downside to the Fed purchases. My guess is that when it’s all over, the Fed’s image might be a bit tarnished and the bloated balance sheets might become more problematic than currently believed. Let’s stay tuned and be prepared while hoping for the best.

(Also, harking back to a previous column, it sure would have been nice if the Fed had been buying bonds when rates were in the mid-teens in the early 80s, but alas that wasn’t policy.)

How About Corporate America? Can They Overpay without Consequences?

Clearly, many stock market participants have been profoundly impacted by the Fed moves. By driving interest rates to virtually nil, they have induced corporate America to borrow huge sums of money to buy back and retire shares of their own stock, a process known as corporate buy backs. The total value of corporate buy backs has been has been at levels only reached once before in history, during 2007 leading up to the Great Financial Crisis. The incentives are certainly there to financially engineer higher “earnings per share”. By borrowing money at super low rates, companies incur modest interest costs, only marginally lowering earnings. However, by using the borrowed funds to repurchase and retire shares of their stock, they decrease the number of shares outstanding so the earnings per share (total earnings ÷ total shares outstanding) magically increase! Corporate management is often highly incentivized to increase earnings per share so the lure is strong.

While leveraging the company’s balance sheets works well in a rising market, I question how well this will play out when prices fall. Notably, stock buy backs were quite low in 2009 when prices were about a third of where they are today. While the math seems to work today, like the Fed with bonds, it is doubtful to me that companies buying back their own shares do so because they believe them to be cheap. Again, does it matter if purchases are made not based on an investment’s inherent value?

Coupon Clippers Now Buying Stocks?

While the Fed may have done what was necessary to save the system in 2009, the ongoing repression of interest rates has had an unfortunately disproportional impact on retirees who had planned to live largely on the interest generated from their bonds and CDs. With inadequate income streams, they have had to either live on less or take more risk and venture into riskier bonds and/or stocks. While the Fed was explicitly trying to induce risk-taking back in 2009, I doubt these non-natural stock buyers were their targets. Unfortunately and perhaps predictably, these naturally conservative savers may have an inordinately difficult time dealing with market declines. Again, these buyers typically haven’t analyzed stocks and determined great value but are simply buying based on the fact that the less risky alternatives are unsatisfactory. I’m very worried about how a bear market might impact them.

Wrapping Up

In my near quarter century as a financial advisor, we have experienced three bear markets and three bull markets. Each bull market has ended when investors en masse make investment decisions disconnected from underlying value. Simply, investors do well when they buy because assets are cheap and typically do horribly when they disregard price and buy for other reasons, e.g. the Internet and real estate bubbles triggered buying simply based on the erroneous belief prices could only go up. Over the last few years, we have witnessed enormous buyers making unprecedentedly large purchases at prices near historical highs,not because they perceive the stocks and bonds to be cheap. Will they really be immune to the consequences we investors experience when we pay too much? Somehow, I doubt it.

Interesting Factoid

Over $5 trillion in government bonds around the world are trading at negative yields! $5 trillion! Who perceives the “value” in purchases that guarantee losses?