I’d be curious to know what you think about the theory Fed asset purchases are driving the market.
The link between Fed balance sheet and stock prices isn’t tight, but there seems to be a fuzzy connection—stock returns were higher than long run average during QE1-3, then went sort of sideways for awhile after 3 ended, after 2016 the global economy was on a better footing and stocks rallied until QT ramped up enough to matter, draining liquidity and the 4Q18 “correction” followed by resumed rallying coincident with “stealth QE” to mitigate illiquidity in the repo market. Then we got the C19 sell off, followed by QE4 > QE1+2+3 and stocks are ripping again.
The transmission mechanism is obviously not banks using the cash to buy equities, but rather increased availability of credit lowerIng the cost of borrow for leveraged investors. When liquidity was draining, it wasn’t a problem for until it hit a critical threshold where the cost to borrow no longer justified levering long for the marginal bet. At this point, someone decides it might be prudent to tighten up the risk exposure, which is effected by selling stocks and repaying lenders. In theory that ought to lead the cost of borrow to adjust down, but institutional changes after the GFC have made banks more risk averse and it’s possible, after the disruptions in the repo market, they decided to derisk too and a cascade ensues. Then the Fed buys $4tr of assets, the banks are flush with reserves, stock valuations are lower and so is the cost of borrow. This changes the calculus for leveraged funds (including derivatives related to equities like SPX futures) and they flip from net sellers of stocks to cut risk in the sell off and maintain margin requirements to net buyers.
Of course if we want to go all Ockham, money printing = devaluation → inflation causing real assets like equities to catch a bid.
This is also something I have yet to study in depth, but the Fed model makes a lot of sense (specifically the capital structure substitution version). Under that model, companies generally use stock issues/buybacks paired with bond buybacks/issues to adjust how much of their funding is from stocks vs bonds, in order to maximize expected earnings per share. That creates a transmission mechanism between bonds and stocks, and is the main thing I’d think about for the sorts of stuff you’re talking about.
More generally, I’m on board with Cochrane’s money as stock theory, although I think he doesn’t implement it quite right—the assets backing dollar value on a day-to-day basis are the SOMA portfolio, not the whole government’s assets and cash flows.
“money printing = devaluation → inflation”—that is kind of obvious—I would start with asking what are the arguments against it. In 2008 it did not work that way—so it looks kind of disproved, but times are changing. The Ray Dalio recent blog posts suggest that the USD global reserve status might be at the end of its cycle. Another thing is that the US government debt it increasing and at some day it will reach one of two reinforcing thresholds: one where investors would start seeing it as dangerous (and demand higher rates) and the other where servicing that debt becomes burdensome and the US government would have to devalue it.
I’d be curious to know what you think about the theory Fed asset purchases are driving the market.
The link between Fed balance sheet and stock prices isn’t tight, but there seems to be a fuzzy connection—stock returns were higher than long run average during QE1-3, then went sort of sideways for awhile after 3 ended, after 2016 the global economy was on a better footing and stocks rallied until QT ramped up enough to matter, draining liquidity and the 4Q18 “correction” followed by resumed rallying coincident with “stealth QE” to mitigate illiquidity in the repo market. Then we got the C19 sell off, followed by QE4 > QE1+2+3 and stocks are ripping again.
The transmission mechanism is obviously not banks using the cash to buy equities, but rather increased availability of credit lowerIng the cost of borrow for leveraged investors. When liquidity was draining, it wasn’t a problem for until it hit a critical threshold where the cost to borrow no longer justified levering long for the marginal bet. At this point, someone decides it might be prudent to tighten up the risk exposure, which is effected by selling stocks and repaying lenders. In theory that ought to lead the cost of borrow to adjust down, but institutional changes after the GFC have made banks more risk averse and it’s possible, after the disruptions in the repo market, they decided to derisk too and a cascade ensues. Then the Fed buys $4tr of assets, the banks are flush with reserves, stock valuations are lower and so is the cost of borrow. This changes the calculus for leveraged funds (including derivatives related to equities like SPX futures) and they flip from net sellers of stocks to cut risk in the sell off and maintain margin requirements to net buyers.
Of course if we want to go all Ockham, money printing = devaluation → inflation causing real assets like equities to catch a bid.
This is also something I have yet to study in depth, but the Fed model makes a lot of sense (specifically the capital structure substitution version). Under that model, companies generally use stock issues/buybacks paired with bond buybacks/issues to adjust how much of their funding is from stocks vs bonds, in order to maximize expected earnings per share. That creates a transmission mechanism between bonds and stocks, and is the main thing I’d think about for the sorts of stuff you’re talking about.
More generally, I’m on board with Cochrane’s money as stock theory, although I think he doesn’t implement it quite right—the assets backing dollar value on a day-to-day basis are the SOMA portfolio, not the whole government’s assets and cash flows.
“money printing = devaluation → inflation”—that is kind of obvious—I would start with asking what are the arguments against it. In 2008 it did not work that way—so it looks kind of disproved, but times are changing. The Ray Dalio recent blog posts suggest that the USD global reserve status might be at the end of its cycle. Another thing is that the US government debt it increasing and at some day it will reach one of two reinforcing thresholds: one where investors would start seeing it as dangerous (and demand higher rates) and the other where servicing that debt becomes burdensome and the US government would have to devalue it.