The myth of hyperinflation series- #2. Fed's toolsEvolution of Fed's QE-
Treasury/municipal bonds-> corporate bond ETF-> individual corporate bond-> Yield curve control (in potential development)-> Maybe... Individual stocks in the future...
As Fed adds more debts to its balance sheet, it hampers its ability to effectively intervene the market in the future. It will need progressively more and more stimulus packages to get us out of the subsequent financial crisis.
Forward guidance-
Odyssean forward guidance: Fed publicly commits the FOMC (Federal Open Market Committee) to a future action.
Delphic forward guidance: Fed merely forecasts macroeconomic performance and likely monetary policy actions.
Try to imagine the following highly improbable scenario- If Fed announces tomorrow that it will raise interest rate to 10 percent and slashes all the govt bonds on its balance sheet, how will the market react? Even something much less extreme of an announcement will and can drive the public sentiment and change the public perception of the market instantly even before the action is actually carried out. Now, that is the power of forward guidance.
Yield curve control (YCC)-
Basically, Fed has strong control over the short-term interest rate, but much less so on the long-term interest rate. In order to influence the long-term yield, Fed would shift purchase toward longer maturities and target some longer-term rate and pledge to buy enough long-term bonds to keep the rate from rising above its target. Fed employs the strategy of selling short-term treasuries and uses the funds to buy longer-term bonds in order to stimulate and spur borrowing, investment and economy if brings short-term rates to zero isn't enough.
Next, we will look at how effective these tools really are by examining few of Fed's past market interventions.
Forwardguidance
Distortion & misallocation & wealth transferThe chart says it all.
3 trillion increase in balance sheet in 2 or 3 months...
Party will go on as long as the long-term interest rate remains low...
Distortion - The massive rally has been partially fueled by $l8 trillion worth of fiscal and central bank stimulus. Short-term lending rate cut to near zero and long-term interest rates dropped to near all time low caused by massive QE.
Massive QE has distorted the interest rate so that the cost of capital is kept artificially low to the point that company is justified to undertake many projects that would not yield any productive return under the normal circumstances
Evolution of Fed's QE -
Treasury/municipal bonds-> corporate bond ETF-> individual corporate bond-> Yield curve control (in potential development)-> Maybe... Individual stocks in the future...
Even though Fed's purchase of individual bonds and ETF accounted for just a small percentage of overall bond market, I can't help but wonder why the Fed included lower-medium grade/slightly speculative bonds and bonds issued by financially healthy companies such as AT&T, UnitedHealth Group, and Walmart ?... to name a few.
Easy credit has undoubtedly kept some zombie company afloat when it is probably better for them to die off.
QE and forward guidance have resulted in high commercial bank deposits. Fortunately, as long as the circulation of velocity remains low and producer can keep up with the demand of good and service, the economy will not overheat.
Misallocation of capital - It is no surprise that American household's wealth is increasingly tied to stock market & real estate. As a result, there is a negative correlation between household wealth and interest rate.
The increased household consumption that results from the perceived gain in the stock market & real estate driven by low interest rate is the main culprit of chronic trade deficit.
Oh yeah, FAANG now collectively accounts for roughly 20% of top stock marketcap...
If it does not convince you that stock market is overvalued, just look at the ratio of total market cap over GDP (currently at 147.2%) and Shiller PE which is 13.1% higher than the recent 20-year average of 25.8.
Wealth transfer -
Pension fund, endowment, mutual fund and hedge fund are having a field day.
Maybe just a handful of investment groups are dictating the movement of the market. BlackRock alone has more than 7 trillion of AUM. Goldman Sachs, Bridgewater and few other investment groups also each controls more than hundred billions of asset.
It is hard to image that the quick reversal in the market is caused by a bunch of retail investors and traders panic sold in March, then immediately FOMO back into the market only a few weeks later.
