Ignore The Pundits, The Federal Reserve Is Not The Source Of The Stock-Market Rally
New York (Jun 14) With U.S. market indices trading around all-time nominal highs, there’s ongoing speculation as to what’s driving investor optimism. Conventional wisdom says the Federal Reserve is and has long been the source of the good cheer.
Supposedly its policies of the recent past termed “quantitative easing” created lots of dollars in search of return, and then the central bank’s pursuit of a zero interest rate caused yield-hungry investors to park their easy money in the stock market over lower-yielding bonds. Apparently government manipulation of markets works after all. Or maybe not.
Indeed, the accepted wisdom about the bull market raises many simple objections. For one, the Fed’s imposition of artificially low interest rates on the way to supposedly easy credit would have to be one of the few instances in global economic history of price controls actually leading to abundance over scarcity. City mayors eager to decree apartments cheap would be lined up to learn the Fed’s secret if a low Fed funds rate had in fact made credit ubiquitous.
Second, if the pursuit of yield is what’s actually luring investors into rapidly rising shares, logic dictates that Treasuries and corporate bonds would have long been declining in value to reflect investor flight away from that which is prosaic, and that is yielding very little. The problem there is that until very recently – and well after the broad rally began – we haven’t seen any substantial bond-market correction. Taking this further, the recent correction of yields upward would, if this theory held any water, be draining equities of vitality. Yet there’s no evidence the latter is taking place.
Third, and assuming this flight of easy money into equities, one investor’s purchase of shares is another investor’s sale. An investor rush into equities with easy Fed money by definition signals a perhaps wiser investor exit from those same equities. There are quite simply no buyers without sellers, except in the unreal theoretical world inhabited by members of the Fed. Supposedly these charitably average individuals who act as though there are buyers without sellers, and even more pathetic, who believe there are borrowers without savers (what else could explain their adolescent decision to lower the Fed’s rate to zero?), can engineer rallies. Read on.
Fourth, markets never price in the present; rather they price in the future. With the quantitative easing side of the Fed’s intervention apparently over, wouldn’t investors be rushing out of the very markets that this easing allegedly caused them to rush into to begin with?
The answer to the above seems to be that markets are so manipulated that equity prices reflect their being the only game in town for investors who want some semblance of return. To believe this, we’d have to believe that central bankers have suddenly figured out how to engineer bull markets.
The problem with such an assertion, particularly one that says low rates push investors into stocks, is that the latter has been policy from the Bank of Japan since the 1990s. Low interest rates across the yield curve have long been the norm for Japan’s central bank, as has quantitative easing, yet the Nikkei 225 is still half of what it was in the late 1980s.
Importantly, a subdued to non-existent equity rally like what’s taken place in Japan is what one would generally expect from central bank manipulation of rates and credit. As we learned in often bloody fashion in the 20 th century, governmental attempts to plan markets by their very description always end in failure. Because they do, and because markets discount the future, one would have to believe that economists at the Fed are either intensely market savvy such that their interventions are actually doing some good; that, or they know how to trick investors about the good of intervention in ways that central banks up to now haven’t known. Neither scenario seems likely for equity markets as deep and informed as those based in the U.S.
Thinking more about the U.S. rally, not asked enough is why the Fed’s borrowing of $4 trillion from banks in order to purchase Treasuries and mortgage bonds (quantitative easing) would excite investors in the first place. Government spending is surely not a driver of economic growth or market health, and then the Fed’s propping up of housing has amounted to it subsidizing consumption over investment in the commercial ideas of the future. Put more simply, quantitative easing has logically been anti-market for it revealing unfortunate overreach whereby the Fed acts as capital allocator over information-pregnant markets themselves.
Furthermore, implicit in the argument that says the Fed is the source of the rally is the belief that absent all the central bank intervention the mood of the markets would be much less exuberant. More specifically, one would have to believe that stock prices and investor optimism would be quite a bit more downcast if the Fed weren’t usurping from the marketplace the allocation of $4 trillion of precious resources, not to mention its attempts to decree credit cheap in the way city mayors have historically tried to dictate low apartment rents. Such a presumption about the direction of markets is not a credible one. As we learned once again in the 20 th century, governmental interventions in markets always end in tears. Because they do, and with equity markets discounters of the future, the better question seems to be how much healthier and higher equity markets would be without all this effort by the Fed to manipulate good times through rate and money machinations.
As for the rally itself, as opposed to our Fed being the source of exuberance, the gridlock that’s prevailed in Washington since early 2012 seems a more likely driver of optimism for it somewhat removing government as a risk to future returns. The same would be said if it were Republican in the White House, but President Obama’s presidency for the most part happily ended in a legislative sense at the end of 2012. We also can’t forget how a strong dollar in the ‘80s and ‘90s coincided with booming equities. In that case, since August of 2011 the dollar has soared against gold while more recently rising against other foreign currencies. When investors commit capital in the U.S., they’re tautologically buying future dollar income streams. Let’s add Ben Bernanke’s merciful departure from the Fed – Bernanke the author of the offense to common sense that was QE – thanks to Obama’s very wise decision to not reappoint him. It’s possible markets are also pricing in good news from the Supreme Court, thus erasing the mistakes of President Obama’s two terms even more thoroughly. If only we could then erase George W. Bush’s presidency too.
What seems unlikely once again is that Federal Reserve manipulation of money, credit and capital has been the source of the stock-market bull. To believe otherwise is to believe that the end of the 20 th century, when decentralized markets ably exposed central planning as wildly flawed, was all a mirage.