By Charles Biderman
There's been a lot of talk about the Federal Reserve rigging the stock market. If you've been wondering, as I have, how it is being done, here's some terrific insight from our own David Santschi. David wrote in this week's TrimTabs Weekly Liquidity Review, "The Fed is exchanging about $4 billion in newly created money every business day for various types of bonds. All else being equal, the Fed's bond buying puts more money in investors' hands to buy other assets, including stocks."
I had thought that the major bond dealers sold back to the Treasury the bonds that they bought from the Treasury, making it pretty much of a wash transaction. What I had not realized, until I saw what David wrote, is that major bond traders-- when they sell Treasuries back to the Fed on the same day-- then buy other bonds from other bond dealers. And as this buying and selling goes down the chain, Voila. Apparently some of the Fed's newly created money ends up in the equity market.
Here is what happens, as I see it now. Every day, Federal Reserve traders are buying about $4 billion in long term treasuries and mortgage bonds from major trading houses. How does the Fed pay for those purchases? Simple. The Fed gives the seller a credit on their Federal Reserve statement. Remember , the Fed is a bank that can legally give away money. Meanwhile, the seller of bonds to the Fed can then withdraw some or all of that money, or leave it on deposit with the Fed.
In other words, the Fed doesn't pay anyone anything. All the Fed does is in essence create new money to give the seller. So let us follow that newly created money. The major dealers who sell the bonds to the Fed can take that money and buy other bonds in the open market. The new seller then gets paid with that newly created money, which in the bank clearing system, acts just the same as money you and I work for.
Therefore, to make this really simple, the Fed creates $4 billion a day and eventually some of that money goes into equities. And that, of course, helps keep stock prices elevated. So it doesn't matter that we are having major problems with the underlying economy and markets that normally would depress stock prices.
So yes, I have been wrong about the market over the past year or so, expecting gravity to kick in at some point. Back last April and May I predicted the market would crack. Why? Mainly because corporate selling was overwhelming corporate buying. The market did indeed start to sell off in late April and May. But then all it took was a hint of a new QE last June to rally the market. As the market rallied, public companies reversed engines. They stopped selling shares and resumed buying their shares to shrink their float. I now think that companies are willing to use zero interest cash to buy back shares as long as stock prices keeps going up.
But when stocks look vulnerable, corporate selling spikes. So in August, I predicted a September market selloff, which did occur for a while. That is, until the next QE was announced.
Recently I have been relatively neutral on stocks because the markets in January have been flooded with cash from investors reinvesting proceeds from year-end tax avoidance selling and bonus income they took last year instead of 2013. Now, when looking at the direction of the markets, I am taking into consideration another source of new money for the markets: The Fed's creation of $4 billion per day in new money. How much of that does end up in stocks? Even if it is only $1 billion, that still is a lot of daily buying power.
In addition to the Fed providing buying power, some market watchers recently have been writing that the Fed's money underlies the trillions in derivatives out there. The big banks have hundreds of billions on deposit with the Fed. That's money created on a computer. Talk about leverage! This is the ultimate leverage. Trillions of dollars in trades on top of hundreds of billions of newly created money.
Why is the Fed doing something that would be a crime if anyone other than the Fed did this? That's because wealth creation is the only policy action of this government that works. It seems that the Fed is willing to keep stock prices elevated, so the Obama administration can keep spending trillions of dollars that really don't exist.
How long can this go on? At some point gravity wins out. For now, equity inflows continue. Let's see what happens when the inflows stop. Will corporate selling surge or not? We will be watching.