The Final Leap: America’s Overlapping Crises May Make Fed Stock Buying Inevitable

The Final Leap: America’s Overlapping Crises May Make Fed Stock Buying Inevitable

“If you don’t think that the mechanical processes that have been worked out over the course of the past month with the Fed now being a top-five holder in many credit ETFs was a test drive for equities purchases, you’re wrong”, Nomura’s Charlie McElligott said earlier this month, in a lengthy podcast interview.

McElligott was loosely referencing what some critics argue is an example of the Fed using semantics to skirt legal restrictions on what the institution can and can’t do in a pinch.

My contention has always been that such discussions are vacuous. We are, in essence, talking about the government and the rules it writes for itself. It’s true that there are procedural hurdles which make it theoretically difficult for one institution to unilaterally take actions not explicitly countenanced under existing laws governing its behavior without the blessing of other government organs which either write those rules or serve as a check, but if the last three years have taught us anything, it’s that America’s vaunted system of checks and balances doesn’t work very well when challenged.

Without delving any further into the politics of the situation, McElligott’s point was simply that the Fed spent the last four months working out the linguistic acrobatics necessary to justify the purchase of risk assets. Although the likes of Janet Yellen have paid lip service to the need for the central bank to ask Congress for expanded authority, you’d be obtuse to believe that such permission would be deemed necessary by the Fed and Treasury given recent events.

“I do think that a lot of the logistical workflow has been dealt with”, McElligott went on to say. “There have even been workarounds with regard to the language of the special-purpose vehicle that’s doing the purchases” of corporate bonds, he added, suggesting the need for a vote or change in the law to allow for stock buying may have been obviated.

So, why might this be necessary?

Well, critics would say there are no circumstances under which the Fed purchasing equities would be necessary and certainly none under which it is advisable.

But leaving aside the normative concerns, I would note that the second half of 2020 is a veritable minefield, and navigating it could be commensurately perilous depending on the evolution of the domestic political situation in the US, the virus, and social tensions, all of which are inextricably bound up with one another.

It’s likely that some of the lasting damage to the economy dealt by the COVID-19 lockdowns will begin to manifest more clearly in the back half of the year. We’re still on track to top 2009 for bankruptcies among firms with $50 million or more in liabilities, for example.

Things continue to get worse for retailers, and some in the energy sector warn that the worst is yet to come there too. “Banks are completely unprepared for what is heading their way. They will need to figure out how to own energy assets this fall”, one E&P executive told the Dallas Fed in a June survey of the industry.

As for households, it still seems unlikely that Republicans will support the extension of the extra unemployment benefits that expire this month. That risks leaving newly unemployed or twice-laid off workers in the lurch. Remember, the collapse in “incomes” during this recession doesn’t look anything like that seen in prior downturns due mostly to the federal response.

I’ve often used a kind of 30,000-foot view to illustrate (see here), but former head of equity derivatives at RBC, Kevin Muir, points to the yearly change, adjusted for inflation (figure below).

“This recession has been dramatically different from the previous ones”, Kevin wrote. “A failure to roll crisis benefits, or an increase in layoffs from a worsening of the virus, could cause total labor compensation to experience a more normal recessionary collapse”.

Obviously, the risk of this is heightened in a scenario where new layoffs accompany the reinstatement of containment protocols in “hotspot” states, and this is to say nothing of hurricane season.

Meanwhile, despite the improvement in the headline jobs numbers, permanent job losses are piling up at the fastest pace since the financial crisis.

“Cumulative damages and ‘scarring’ from the pandemic have a time component as an important dimension – the longer it lasts, the more severe its consequences are likely to be”, Deutsche Bank’s Aleksandar Kocic wrote Friday.

“Policy can only be reactive in covering those damages because its scope and magnitude is unknown ex-ante — it is dependent on the duration of the crisis”, he went on to say, adding that “unlike in financial economics, where our expectations feed back into economic and market reality, in the real world, they do not”.

Risk assets, Kocic says, are still vulnerable to the realization of the “scarring” effect and especially to another escalation of the pandemic and the myriad other socioeconomic and political risk factors strewn across the calendar in the back half of the year.

Although risk assets have obviously benefited from the stimulus measures, Kocic cautions that they have a “relatively high negatively convex exposure as a verdict about the extent and scope of the crisis remains out of grasp”.

That harkens back to the VIX which, as discussed at length in “‘5 Major Crises’ And ‘The Big Whipsaw Of 2020’“, remains disconnected from equities and, as it turns out, other measures of volatility.

Simple ratios of the VIX to rates and FX volatility remain extraordinarily elevated. “While the spike in March was the doings of VIX, subsequent slow decline has been the effect of both the numerator and the denominator and their uneven decay in subsequent normalization of the markets”, Kocic wrote Friday.

He calls the uneven character of the decline “somewhat unusual”. After all, all markets are dealing with the same information, and while it’s only natural that volatility ratios should spike occasionally when idiosyncratic factors conspire to affect one asset class more than another (e.g., the implosion of the VIX ETP complex in February of 2018), Kocic writes that the current episode, to the extent it persists, highlights “the residual uncertainty about the way markets are metabolizing the effects of demand shock in the near-term”.

That latter point is key, and it shows up in the de-correlation of the VIX with rates and FX vol. The steep declines shown in the figures (below) don’t have much in the way of precedent in the last 15 years, outside of the financial crisis and the taper tantrum.

Kocic goes on to write that “the exogenous shock which activated the current configuration of intersecting crises has exposed the underlying negative convexity of the economy”.

This has been compensated for in rates by central banks (which are back in the business of supplying convexity, not just managing it), while the coordinated nature of the global monetary policy response means the effect has been distributed across FX. That leaves equities to metabolize the shock. As Kocic puts is, “The key question is the mode of realization of this negative convexity, its distribution, and the locus with its highest concentration”.

Looking ahead, it’s not terribly difficult to conjure any number of scenarios which could prompt another bout of severe turbulence for stocks, especially given the direct transmission mechanism from the “scarring” effect on the economy. Structural damage means activity and output resets sustainably lower, all else equal, which should then translate into lower earnings, and thereby falling equity prices, especially considering rates cannot go much lower.

Again, the intersecting nature of the multiple crises facing the US means it may be more difficult for markets to shrug off political turmoil and societal unrest. These issues overlap now, arguably more than ever.

“As the unrest was materializing, there was an element of the COVID anger built into that”, Nomura’s McElligott notes. “There was a little bit of a multiplier there”.

For Deutsche’s Kocic, the decoupling of the VIX from other measures of volatility could persist. “This is especially likely to remain if we see further escalation of the pandemic or in the case of other event shocks”, he wrote Friday. “While rates and FX stability might remain protected by policy response, risk assets are likely to be on the front line”.

Whether or not the Fed will “allow” things to spiral anew is the question.

Over the course of his trial by fire, Jerome Powell became quite adept at marshaling the tools at his disposal to tamp down measures of stress wherever they popped up, from dollar funding markets to high yield spreads. Colloquially, he became something of a carnival Jedi — the guy who shows up at the arcade once every six months and somehow wins Whac-a-Mole, an unwinnable game by design.

“The other thing I would add, is that there is also a view that around any kind of shock-down — if the market were to go vigilante — the Fed stands ready”, McElligott said on July 2.

The irony, of course, is that if the Fed does get into the business of buying stocks, it will only exacerbate some of the key factors contributing to the dynamics at the heart of the worst societal unrest America has seen in five decades.


32 thoughts on “The Final Leap: America’s Overlapping Crises May Make Fed Stock Buying Inevitable

  1. I think the FED, Treasury (or their agents) are already buying stock futures…….they pop up most days after the close, when the market gets thin and easy to move.

    1. Let’s not with the conspiracy theories — it’s misleading to readers who may not have the wherewithal to parse what’s real and what’s pure speculation, and it also perpetuates memes that have been popular on websites of questionable motives.

      1. @TRH Are you also suggesting that the BoJ or Swedish SWF might not be the source of the overnight bounces? What about the Saudis, or UAE or some other ME concern with a vested interest in maintaining the facade of asset prices and capital velocity?

  2. It’s likely hedge funds stepping in to screw the price-driven models. It’s relatively easy to move the futures to the model trigger points in a thin, overnight market. Sharks preying on other sharks!

  3. It seems more than likely that the fed becomes the equity buyer of last resort further cementing momentum as the permanent winner, socializing the costs of wallstreet mistakes. The end result is a strange state where the wealthy are guaranteed to win at their casinos while everyone else is guaranteed to lose at their jobs. If the fed can go this far… surely it can also skip right to direct UBI but it won’t and that will drive extreme social unrest.

  4. Most comments one reads are based on whom ever wrote them and their ideological inclinations….Looking on a longer term view there has been a radical level of acceleration in what I like to refer to as goalpost moves in recent years. If one were to go back to (arbitrarily ) about the time of the Greek Financial Crisis this would appear obvious..
    So maybe we are talking about long term permanent changes and the viability of a system that is adapting or trying to adapt to levels of stress that can be construed in an (objective ??) analysis as potentially terminal… We as a group all derive a lot of benefit because there is a diversity in opinions expressed here and it is apparent no one has a solid lock on what the future will or should look like.. The discussions related to MMT over the past six months exemplify some of the above…Sorting out the self interests of the powers that are driving the actions that control the direction of change is the ultimate challenge …..

  5. Sorry, I might be a simple mind, but it is the credit market which is important, who cares if stocks have a downturn, who cares if Tesla crashes? Jerome Powell himself indicated something like it are the poor and middle class that needs help, implying not the stock market……

    1. Credit and the stock market inextricably linked, so the stock market is just another “policy tool”. When you have an employment and inflation mandate, it’s not hard to see jumping from fallen angel credit support to outright HY and stock index purchases.

    2. I agree. I fail to understand the rationale for the Fed buying stocks. Protecting pension funds? banks and insurance companies? The rich hold so much sway over politics that they even stifle the discussion on blog sites.

  6. The question is, what stocks does the Fed buy. Do they index, with the resulting distortions? Do they buy FAANG type stocks regardless of valuation, or do they act as the equity buyer of last resort and buy moribund equities? And to what extent does it fulfill its primary purpose by propping up equities?

      1. In that case, one needs to sell everything else and buy those companies, hopefully front-running the Fed. It’s bigger than all the big hedge funds put together, and only the stocks it buys will go up, regardless of fundamentals, charts or stories. It would be a different market.

  7. Heisenberg’s arguments for the Fed buying stocks:

    Trump offends me, he hasn’t ‘played by the rules’ (I assume you still buy into the Russia conspiracy, which you’ve subjected readers to for several years now). If Trump doesn’t, then… needs to, so…. the Fed should be allowed to buy stocks?
    “Structural damage means activity and output resets sustainably lower, all else equal, which should then translate into lower earnings, and thereby falling equity prices” -> What that describes, is the market trying to do its job and (somewhat) efficiently price assets. I don’t know when that became a crime.

    The “intersecting nature of the multiple crises facing the US means it may be more difficult for markets to shrug off political turmoil and societal unrest” -> So be it. I don’t know at what point equities going lower suddenly means in your eyes that a central planning authority should step it to prevent it. That argument’s as ridiculous as saying Netflix had a great quarter, investors are trying to price in a higher value, but some of this windfall was due to the virus, which wasn’t its fault, so let’s hike rates.

    1. H, correct me if I’m wrong, but he’s not arguing that the Fed should buy stocks – only that they are setting themselves up to be able to do so. H has made it clear on numerous occasions that he thinks we need fiscal policy to address the challenges we have faced and continue to face or we will continue to see the primary causes of societal unrest get worse with increasingly worse consequences across the board.

      As for letting the market collapse, the Fed has stepped in to prevent a repeat of the Great Depression while the federal government abdicates its duty to promote the general welfare of the country. Yes, in an ideal world, we’d let price discovery and market dynamics work their magic, but we don’t have to sit on our hands and let the entire market collapse because of some freak event like a pandemic and the unwillingness of the federal government to actually step up and address the problem instead pretending it doesn’t exist or is a hoax..

      1. Yes the pandemic was a “freak event” as you mention. But what turned this freak event into a deep systemic crisis (apart from poor leadership from the West, in general), was the Fed’s terrible policies over the past 2 decades. They incentivised risk taking, piling on debt to buy back shares, punished saving, greatly expanded wealth inequality.

        Boeing is the poster child for the Fed’s reckless decisions, and if it wasn’t the pandemic, the system would have collapsed on something else. Last time I checked, record corporate debt, record wealth inequality, record misallocation of capital, most people living pay check to pay check etc., isn’t a recipe for stability.

        1. I agree and those dynamics have been documented extensively on this site. See here for the latest example:

          That is why H and the people on this site keep harping on the idea of fiscal policy and creating a much stronger social safety net. That is the only way to get the Fed out of the business of trying to play the hero unless you would prefer Great Depression redux.

          I would also note that the Fed’s hand has basically been forced. The market’s taper tantrums showed what happens when the Fed tries to normalize rates. Even if you think the Fed should’ve ignored the taper tantrums, Powell would have been quickly replaced by our president who would not have stood idly by while the market dropped. The president made it very clear that he expected an accommodative Fed.

          1. I never said the Fed should buy stocks. This isn’t a prescriptive article and it’s not meant to be a policy recommendation.

            Peter wanted an excuse to say something about Donald Trump, so he conjured one out of thin air in a bid to start an internet argument with anyone willing to engage.

            Generally speaking, that is not how I would recommend spending one’s Sunday — bickering with others on the internet, that is. Other ideas include: Reading, writing, running, leaving constructive comments (and every other comment here is constructive, as are most parts of Peter’s comments) or anything that’s conducive to self-improvement.

            It makes sense to needle those who write for public consumption when the articles appear on sites the author doesn’t control and/or in settings where the author is restricted in their capacity to respond. But, Peter, this is my house. I own it. You’re just a guest. And you’re certainly welcome to hang out. I’ll even feed you chips and salsa. But don’t sneeze in the salsa, Peter. That’s not a very nice thing to do.

  8. If the elected officials of our country can not enact policies to fix these problems ( Congress) then we have other way more serious problems than worrying about whether or not the Federal Reserve ( not elected officials) will buy equities.

    Presently, we are still a democracy.

    Time for a new group of elected representatives who are willing to work hard to solve problems and have a vision for the future of our country- which hopefully finds a better way to reducing the wealth gap than just printing USD.

  9. Gibbon famously concluded that the decline and fall of the Roman Empire was largely attributable to the loss of civic virtue in its population. A lot of civic virtue was traded in for a neoliberal-monetarist idea of capitalism about a half century ago now, and it has been rationalized for so long against empirical evidence that the internal contradictions have built up to this point of acute irony – with this final leap of buying stocks, the FED will complete its nationalization of the corporate sector. Right-wing ubercapitalism will in fact have delivered Sovietization. The paradox will likely not be appreciated. America will continue to see itself as fundamentally different from China, despite the close similarities of the two economic systems. At some point, or perhaps gradually, fed up with the self-serving hypocrisy and corruption of the ruling class, oppressed Americans will lose their civic virtue as well, and there will be none left.

  10. This may sound old fashioned–but the Federal Reserve act needs to be changed in order to buy stocks. True, the Fed has bent its authority under the guise of restoring “functioning” to first Treasuries and MBS and now into IG and HY. It used the SPV work around. Can they do that for equity ETFs? Maybe. In April, Yellen said the Fed would need Congressional approval. I am asking more than anything else. I suppose the cynic just imagines the Fed, a body that has hardly any legislative accountability, can pretty much do whatever they want and the Yellen objection is not really an objection at all. I want to hope, for the sake of the country, that the prohibition on buying stocks is a higher bar than it appears to be for the BOJ.

  11. From what I have read elsewhere (SA), through June 30, the Fed has purchased $9.6B of corporate bonds out of the $250B facility.

    The universe for corporate bonds is $10.5T.

    At the current pace of $1.0B corp. bond purchases/week— a lot of bonds will get purchased before the Fed moves on to equities.
    Can the Fed print enough USD to purchase equities, let alone a meaningful chunk of the corporate debt universe? Seems unlikely.

  12. There is a non-zero chance that the elections in 113 days will bring in a Democratic president and a Democratic majority in the senate, to add to the existing Democratic majority in the house. There is also a non-zero chance that the Democratically-controlled senate will suspend filibuster rules, once seated in January 2021. One would imagine that in that circumstance, you might hear of more imaginative proposals for investing in America, besides simply allowing the Fed to buy the stock of publicly-traded companies. There are in fact many interesting possibilities that you might see as hybrids. Why not buy out poorly-performing publicly-traded manufacturing companies and use them to both increase employment and manufacture strategically-important goods, such as medical supplies (PPE), generic drugs, etc? Invest in Boeing–to manufacture solar panels, wind turbines, etc. Call it socialism or state capitalism–if it’s going to happen in some form or another, there are many who beileve that it might as well go towards making the country more resilient and boosting employment, rather than simply increasing the fraction of wealth owned by the wealthiest Americans.

  13. A bear market is “nature’s way” of cleansing and resetting our financial economy, much like a fever kills viruses. Is there anyone who deep down doesn’t really believe that we’re just prolonging our misery, with very deleterious long-term effects, with these (potential) market shenanigans? At what point did it become so God-awful for our policy makers to even consider the possibility of a significant reset in the markets. It’s truly sad and suggests that the framework must be truly rotten underneath the facade…

  14. Joey: this is called « Corporatism » and has been practiced by Europeans (France and Germany) until circa 1990/2000. Worked well for them.

    About the « legality » of central banks buying stock, how have the other central banks worked around? On its practicalities, how have these central banks voted (asking for a friend)?

    When you add the discussion on tax reform that would include taxing capital gains and dividends more like normal income or raising corporate tax, you see that essentially the government will end up being a bigger shareholder of the « public «  sector in what form or another, which form is preferable? Again, how would or should they vote at SH meetings?

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