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When investors buy stocks, stock prices rise. That is the immutable law of the market. It doesn't matter if the money comes from big financial institutions, Mom and Pop day-traders or Central Banks. The same rule applies: Buy more stocks and prices go higher.
So when the Federal Reserve launched its recent "repo rescue" operation, which provided a whopping $60 billion of additional liquidity per month plus billions more in cash-for-collateral, naturally, stock prices rose quite sharply.
Of course the financial media is not going to admit that the Fed's intervention is pushing stocks higher, but that is, in fact, what's happening. The Fed is expanding its balance sheet, boosting reserves at the banks and providing hundreds of billions in low interest short-term loans to repo participants. The extra liquidity is pushing stocks higher just as it did when the Fed implemented QE.
According to an article at the financial blog, Wolf Street: From "mid-September, 2019, (to) January 1, 2020, the Fed added nearly $410 billion to its balance sheet" which is an astronomical amount of money. The Fed purchased mainly T-Bills in order to build up reserves at the banks so repo transactions could take place without pushing up interest rates. Some readers may recall how this same policy, Quantitative Easing, was used during the financial crisis. The Fed launched 3 rounds of QE, purchased trillions of dollars of US Treasuries and Mortgage-backed Securities (MBS) which, in turn, sent stocks into the stratosphere.
This time, the Fed doesn't want the media to refer to QE as QE because they're afraid that people will figure out that (a) the crisis never ended and (b) the Fed is once again jacking-up stock prices. Not surprisingly, the servile media has complied with the Fed's request, but that doesn't change what's really going on. The Fed has lowered rates to their emergency setting and is hosing down the entire repo market with hundreds of billions of dollars to forestall another system-wide meltdown. And the funny thing is, the Fed hasn't the slightest idea of what the problem is. That might sound unbelievable, but I assure you, it's true. We are spending a half a trillion bucks on a glitch that has not yet been identified and could be nothing more than a manipulation of liquidity by one of the big banks with the intention of forcing the Fed to restart QE. In other words, one of the big boys could be just pulling the wool over the Fed's eyes.
Even so, the Fed is purchasing $60 billion per month in (mainly) T-Bills to build reserves at the banks while, at the same time, offering billions more in cash for overnight and 14-day loans. What we want to know is whether this money-dumping operation boosts stock prices or not? The answer to that question can be found in an article at Investopedia that explains the basic theory:
"The Federal Reserve's large-scale asset purchases (LASP) plan, also known as quantitative easing (QE), affects the stock market, but it is difficult to know exactly how or to what extent. Empirical evidence suggests there is a positive correlation between QE and a rising stock market; some of the largest stock market gains in U.S. history occurred after the launch of an LSAP. There are several possible explanations...When the Federal Reserve begins entering the market to purchase financial assets, it manipulates price signals in three significant ways: lower interest rates, higher demand for assets and reduced purchasing power of money units. Instead of stock prices acting as an accurate reflection of company valuation and investor demand, manipulated prices force market participants to adjust their strategies to chase stocks that grow without their underlying companies actually being more valuable." ( Quantitative Easing impact on the stock market, Investopedia)
If you scan the Internet, you'll find hundreds of articles that basically say the same thing. The Fed and its defenders might refute these claims, but among the cadres of veteran traders and market watchers, the matter is settled science. QE leads to asset inflation, more risk-taking, higher stock prices and windfall profits for the investor class.
Not surprisingly, the Fed's repo intervention has produced the same result. By flooding the market with liquidity, the Fed has prevented rates from spiking, but also buoyed stocks on an ocean of digitally-created cash.
So now there's enough money in the system to swap collateral (Triple A-rated securities) for short-term loans at below-market rates. It all sounds very complicated, but it's not. Repo (repurchase agreements) is no different than going to the local pawn shop and handing over your chain saw and roller-blades for a couple bucks so you can go bar-hopping with your sketchy buddies on Saturday night. Then, when you get paid on Monday, you head back to the pawn shop and buy back your stuff at a slightly higher price. Repo works the same way. I give you my MBS or US Treasuries and you give me the money I need to keep the wolves away from the door. The problem with repo is that it is a grossly-under-regulated $2.2 trillion per day operation that involves a handful of under-captitalized clearinghouses, some very dodgy borrowers, and a Central Bank that is only too eager to provide lavish bailouts at the drop of a hat. This lethal combination laid the groundwork for the current crisis.
Keep in mind, not a dime of this money trickles down to working people or the real economy. All the money remains stuck the financial system where it's used to maximize leverage, distort prices and inflate assets so wealthy 1 percenters can buy the wife another bauble at Tiffany's or put a "down" on that fetching vacation cottage on Martha's Vineyard.
But how does it work? How do the Fed's liquidity injections push stock prices higher, that's what we want to know? Check out this clip from Wall Street on Parade:
"Cumulatively, since the Fed began making these unprecedented repo loans to Wall Street’s trading houses on September 17 of last year, it has pumped over $6.6 trillion into Wall Street.That money has found a home in the stock market, most likely via stock index futures which deliver a big bang for the buck through high leverage via margin loans. Some of these Wall Street trading houses that are borrowing from the Fed at 1.60 percent are likely loaning that money out to hedge funds (at a much higher interest rate) and the hedge funds are then plowing the money into stock index futures.
The stock market has set repeated new highs since the New York Fed turned on this multi-trillion-dollar money spigot that has been operating every business day since September 17." ( "The Fed Has a Dangerous Repo Problem: Here Are the Charts" Wall Street on Parade)
Of course, the Fed is not directly purchasing the shares of individual companies listed on the S&P 500 or the Dow Jones Industrial Average, but the effect is largely the same. Giant sums of money are being pumped into the financial markets, which draws in more buyers who push up prices. Simply put, the Fed sticks money in one end and, bingo, stocks shoot higher on the other. Here's how the Management Study Guide sums it up:
"When there is an expansionary quantitative easing (QE) policy announced, the market becomes bullish and stock prices begin to go up. On the other hand, quantitative easing (QE) tapering contracts the economy, then the markets become bearish and stocks tend to go down in value."
( Effect of Quantitative Easing on Stock Markets, Management Study Guide)
Simple, right? And it all goes back to our original thesis which is: "When investors buy stocks, stock prices rise." In this case, more cash in a closed system inevitably inflates the value of the assets in that system.
The Fed justifies this manipulation by saying it is just maintaining control of short-term interest rates, which is partially true, but misleading all the same. The reason short-term rates spiked in September is because other participants in the repo market became less willing to provide cash for collateral to other financial institutions. But why would they do that, after all, they make money on these loans, don't they?
Yes, they do, which suggests that something else might be going on below the radar. There could be a big bank or financial institution that's in trouble and can't get the funding it needs because other lenders do not feel confident they'll get their money back. That is the most likely explanation. But which bank would that be? Once again, Wall Street on Parade has a hunch and backs it up with some interesting facts. Check it out:
"Deutsche Bank has been a constant headache for the U.S. financial system because it is heavily intertwined via derivatives with the big banks on Wall Street, including JPMorgan Chase, Citigroup, Goldman Sachs, Morgan Stanley and Bank of America....On the day the police raid started at Deutsche Bank, Tuesday, September 24, the Federal Reserve Bank of New York offered $30 billion in 14-day emergency term loans and had demand for more than twice that amount. That led the New York Fed to increase its subsequent 14-day term loans from $30 billion to $60 billion later in the week. The Fed’s overnight repo loans that were offered every day last week were also increased from $75 billion per day to $100 billion per day....
Wall Street On Parade believes that the repo crisis on Wall Street may, at least in part, relate to big Wall Street banks backing away from lending to Deutsche Bank. You can read the timeline below and make up your own mind."
( The Repo Loan Crisis, Dead Bankers, and Deutsche Bank: Timeline of Events" Wall Street on Parade)
This would explain the sudden spike in rates as well as the surge in demand for 14-day loans. But, still, how do loans help a bank that could be insolvent, after all, a loan has to be repaid, right?
Well, that depends on whether the loans are actually repaid or just rolled over indefinitely. If they are rolled over indefinitely, then they're not a loan at all, they're a bailout. Here's more from Wall Street on Parade:
"Neither the public nor Congress have any proof that these repo loans are being unwound. One or more of the 24 trading houses on Wall Street (primary dealers), that are authorized by the New York Fed to borrow from its money spigot at super cheap interest rates, could simply be rolling over the same loans or using term money to pay off one loan while taking out another loan.There is a mountain of evidence to suggest that this is exactly what is going on."( Are the Fed's repo loans being repaid by Wall Street's trading houses or just rolled over and over, Wall Street on Parade)
Ah ha, so the Fed's liquidity operations could really be a stealth bailout?
It sure looks like it. We already know that the Fed has a history of stretching the rules, ignoring its mandate, and bending over backwards for its Wall Street constituents. We can also assume that the Fed would rather prop up an underwater bank with giant sums of money than deal with the fallout from another financial cataclysm. That seems like a reasonably safe bet too.
But let's not forget this other part of the story that popped up in the January 14 edition of the Wall Street Journal. Take a look:
"Hedge funds currently borrow through a process called sponsored repo, in which they ask a large bank to act as a middleman, pairing their government bonds with money-market funds willing to lend cash. The bank then guarantees that the parties will fulfill their obligationsâ€"repaying the cash or returning the securities.........Some fear that lending directly to hedge funds could lead to the perception the Fed is fueling risky bets."
( Hedge Funds Could Make One Potential Fed Repo-Market Fix Hard to Stomach, Wall Street Journal)
Huh? So the Fed is lending cash to the diciest, fly-by-the-seat-of-your-pants, riverboat gamblers on Wall Street, the hedge funds?
Yes, it is. And, keep in mind, a hedge fund, by definition, is "a limited partnership of investors that uses high risk methods, such as investing with borrowed money, in hopes of realizing large capital gains." In other words, they're speculators whose sole objective is to maximize paper profits by increasing leverage and taking risks.
Is this why the Fed swung into action at the first sign of trouble, because they wanted to make sure that these scavengers got the the dough they needed to fund their casino operations?
Probably, but the jury is still out. One thing is certain though, all these free-wheeling hedge funds have numerous counterparties which means that if one domino tumbles, the rest will soon follow. And that is the nightmare scenario the Fed wants to avoid at all cost. Unfortunately, the Fed's latest intervention cannot reverse the effects of bankruptcy. If a major bank or hedge fund has already drowned, it's only a matter of time before the body bubbles up to the surface. And that's when all hell's going to break loose.