What on Earth Is Happening in the Financial Markets?

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Current Federal Reserve Chair Jerome Powell

Introduction

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Figure 1: One-Year Dow Jones Chart

In general, markets are forward looking, but economists are definitively not forecasting a V-shaped economic recovery. So how did the stock market bounce back so quickly? As many investors have deduced, the Federal Reserve, or the “Fed” for short, has played a significant role (see the popular meme “Money printer go brrr”). But what exactly is the Fed, how does it support the markets, and could that support ultimately have long-term negative consequences? (Spoiler: It depends.)

In this three-part article, I answer those questions and put the current financial conditions in a historical perspective. In Part 1, for clarity, I define the terms that I refer to throughout the article. Then, in Part 2, I chronicle the Great Recession and 2010s recovery and how they brought the system to its pre-pandemic state. Finally, in Part 3, I explain what has happened so far in 2020, where things may go from here, and why given all that, the US suffers from extreme wealth inequality.

Part 1: Definitions and Background Information

Stock

To entice investors, my company’s stock can pay them dividends, perhaps an annual payment of something like 2% of the share price. If earnings go up, I can raise total dividend payments, making investors more bullish and driving the price (and my net worth) up. In turn, the 2% figure will stay relatively constant. On the other hand, the opposite of all those events will happen if earnings go down. Also, if investors think my company will grow in the future, they may bid up the price to a high price to earnings (P/E) ratio; such stocks are called growth stocks, as opposed to value stocks, which often have lower P/E ratios. For example, Amazon is a growth stock, and Berkshire Hathaway is a value stock.

From the investors’ perspective, they get dividends (though dividends are never guaranteed, and not every company pays them), but their principal may go up or down. To diversify against risk, many investors invest in index funds, or collections of stocks, which are often weighted by market cap (that is, total shares × price per share). Stock index prices usually go up in the long run with economic growth, but there have been periods of declining prices.

(Aside 1: Instead of paying dividends, some companies buy back shares from the open market. This process, known as stock buybacks, drives up stock prices and serves as an alternative way to transfer wealth to investors. It has also generated criticism for two reasons. First, relative to dividends, buybacks favor speculators over long-term investors. Also, buybacks have become more commonplace, so earnings that could be going to research and development are going to buybacks.)

Bond

Unlike with stocks, your principal remains fixed, and yields for existing bonds typically cannot be changed. Therefore, if you own a bond and want to sell it on the open market, you have to compare your bond’s yield to the yield for newly-issued bonds of the same type. If the new yield is lower, you can sell your bond for a profit because your bond pays more. But if the new yield is higher, and you still want to sell, you have to sell at a loss. As such, bond prices move in the opposite direction as yields. In addition, regular bonds pay their yield gradually over time as coupons, whereas zero-coupon bonds pay all their yield when they return your principal at maturity.

There are three main types of bonds: US Treasurys, municipal bonds, and corporate bonds. US Treasurys are issued by the federal government and have no default risk because the US can print money to repay the debt. In fact, the national debt is largely the sum total of the Treasurys. Meanwhile, municipal bonds are issued by state and local governments, and corporate bonds are issued by companies. If a company issues stocks and bonds and goes bankrupt, bondholders are paid back before stockholders.

Inflation

Inflation can induce a positive feedback cycle; if your dollar will be worth less tomorrow, you will want to get rid of it today, further decreasing the demand for and value of dollars. In other words, the velocity of money, or the rate at which a dollar changes hands in the economy, will increase. As such, inflation can change independently of supply shocks or the money supply (all else equal, more money means more inflation). If inflation goes too far, there may even be hyperinflation, where the currency can become worthless. Ultimately, increases in the inflation rate may lead to economic instability and even social unrest, which in turn may suppress growth.

Alternatively, in a bad economy, people may hoard cash for fear of not being able to pay their bills. Consumer spending goes down, so fewer dollars chase the goods in circulation, leading to deflation, or a decrease in price levels. Deflation can also induce a positive feedback cycle because without sufficient demand for goods, workers get laid off, inducing higher unemployment, more fear, and greater deflation. Policymakers tend to want manageable inflation to promote stability and growth; the current inflation target is 2% per year.

Business Cycle

Now suppose there is a negative shock that induces a recession, or a sustained decline in the production of goods and services. (We are officially in a recession; the last monthly economic peak was in February.) Corporate earnings will suffer, plus some companies may do poorly even after the economy recovers. New companies will rise up to replace the struggling ones, but it is hard to identify promising new companies in the short run. So investors sell stocks until stock prices fall low enough that stocks become attractive again. This is what an equilibrium heading into the trough of a business cycle looks like.

Investors try to be forward looking, so economic conditions often lag stock prices. Meanwhile, bond prices are a little more complicated. For instance, junk bond prices tend to behave like stock prices because defaults increase in recessions. In contrast, when faced with a recession, investors may bid up Treasury prices because Treasurys are the safest bonds. Then again, if that recession is inflationary, investors will probably avoid Treasurys unless Treasury yields are high enough to keep up with inflation.

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Figure 2: Business Cycles

Federal Reserve

Historically, the Fed’s main tool to stabilize the banking system has been setting the federal funds interest rate (fed funds rate), or the rate at which banks lend to one another. This rate is similar to what you get on a savings account or on T-bills, which are the shortest-term Treasurys, mature in one year or fewer, and unlike most longer-term Treasurys are zero coupon.

The fed funds rate is currently set in a target range, which the Fed maintains via open market operations, or the buying and selling of short-term Treasurys on the open market. Specifically, if the Fed wants to lower rates, it digitally prints money to buy short-term Treasurys from banks. (Banks often invest the cash they receive from depositors in short-term Treasurys.) Flush with excess cash, banks then become more willing to lend to other banks at lower rates. In contrast, if the Fed wants to raise rates, it sells short-term Treasurys to banks, decreasing the money supply and incentivizing banks to lend at higher rates.

Notably, the Fed cannot unilaterally give money to people; that is, it does not have a magic money printer. Rather, its power is limited to trading one type of government security, such as cash, for another, such as short-term Treasurys. However, the Fed does return to the government any net income from its assets, which means it can help finance government spending.

The Fed usually lowers rates during recessions and deflationary periods to stimulate borrowing and investment. For example, in 2008, it lowered the fed funds rate to 0–0.25% as the economy was contracting. Meanwhile, the Fed raises rates during expansions and inflationary periods to reduce speculation and incentivize people to hold on to their cash in savings accounts. Rising rates also cause bond yields to go up, which makes newly-issued bonds more attractive and stocks less so by comparison. As a result, stock prices may drop too. For example, the Fed induced a bear market in stocks and bonds in the early 1980s by raising rates as high as 20.00% in order to stop inflation. Ultimately, the rate that stabilizes the economy is called the “natural rate.”

(Aside 2: To help control the fed funds rate, the Fed can also set the discount and interest on reserves (IOR) rates. The discount rate is the rate at which banks are allowed to borrow from the Fed; banks will not borrow from other banks at a higher rate than the Fed is offering. On the other hand, the IOR rate is the rate at which the Fed pays banks to hold cash reserves; banks will not lend to other banks at a lower rate than the Fed pays them to hold reserves. Lastly, the Fed can change the reserve requirement, or the amount of reserves banks must legally hold. Lowering this requirement encourages banks to lend at lower rates and vice versa.)

Fiat Money

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Figure 3: Historical Gold Prices

After that, the US switched to a fiat money system, in which the dollar is tied only to the intrinsic demand people have for it. For example, you need dollars to pay your taxes or dollar-denominated debts. A fiat system gives the Fed more flexibility to control the money supply and stabilize the business cycle. But historically, fiat currencies have often become worthless in the long run because it is very tempting for countries to devalue their currency. For instance, when a country devalues its currency, it cheapens its goods on the global market, making it easier to increase exports and reduce imports.

Fortunately, the US dollar has remained the global reserve currency since 1945 (that is, since the end of World War II), which means foreign countries and banks hold dollars to transact with one another. This system ensures the dollar has value, even when the US is printing a lot of it. It has also led to foreign banks creating their own, less regulated version of our fractional-reserve system, which is known as Eurodollar system. In addition, the US can always cover foreign, as well as domestic, debts denominated in dollars (this privilege can theoretically further incentivize the US to devalue the dollar). However, switching to fiat money was an additional reason for the high inflation in the 1970s.

Part 2: The Great Recession and the Fed’s Response

Causes of the Great Recession

However, the housing bubble was much worse in part due to mortgage-backed securities (MBSs). A mortgage is analogous to a bond in that a lender loans you money to buy a house, and you repay the lender over time plus interest. Like bonds, mortgages can be bought and sold as financial assets; if more investors want to buy mortgages, the rates on mortgages go down, and vice versa. In addition, the greater the default risk on a mortgage, the higher the rate. Lastly, mortgage rates often move in tandem with the fed funds rate.

Provided defaults are not correlated with one another, investors realized they could reduce their total risk by pooling mortgages together as MBSs. They then combined MBSs with other debt assets; such combinations are called collateralized debt obligations (CDOs). There was even an insurance market of credit default swaps (CDSs) where people paid others to assume the risk of their MBSs and CDOs. Due to the low-rate environment, MBSs and CDOs were in demand as higher-yielding alternatives to Treasurys. Homebuyers also took out adjustable-rate mortgages, which were opportune while the Fed was cutting rates but then became a burden when it raised rates during the mid-2000s expansion.

Eventually, almost everyone in good financial standing who wanted a mortgage had one, so lenders started issuing subprime mortgages to less-qualified people, leading to a correlated increase in defaults in 2007. As a result, sellers of MBSs started to outweigh buyers, causing mortgage rates to go up further, and in turn inducing a spree of adjustable-rate mortgage defaults. That then caused many MBSs and CDOs to go bust, even though they were rated as investment grade. Finally, CDSs were unregulated, so some of the insurers were never prepared to assume the default risk.

By 2008, all these events burst the housing bubble, and banks holding housing assets lost a lot of value while people were simultaneously having their homes foreclosed. This collapse set off a global deflationary recession severe enough that steadily decreasing the fed funds rate from 4.50% in January to 0–0.25% by December was insufficient to stop the bleeding.

(Aside 3: The only larger recession was the Great Depression, which began with a stock market bubble in which people borrowed money to buy stocks on margin. Once sellers started taking profits, stock prices dropped, causing investors to get margin called and go broke. A misguided tightening of monetary policy, plus the 1930 Smoot-Hawley Tariff and the crop-killing Dust Bowl, made things worse.)

Fed’s Response

So the Fed started quantitative easing (QE), which entails printing money to buy MBSs and longer-term Treasurys. Ultimately, the Fed bought enough longer-term Treasurys that their yields dropped close to short-term Treasury yields. In essence, the Fed flattened the yield curve, or the set of yields for Treasurys of all times to maturity. As a result, investors stopped selling stocks in favor of Treasurys at low stock prices, thus kickstarting the stock market recovery. In October 2014, the Fed finally ended QE with the market at then-record highs, right as Europe started trying QE for itself.

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Figure 4: Types of Yield Curves

(Aside 4: During World War II, when the national debt to GDP ratio was very high due to wartime government spending, the Fed employed a similar tool called yield curve control to help finance that spending. Rather than necessarily buying Treasurys, the Fed promised to buy them at the prices needed to support its target yields of 0.375% for T-bills and 2.5% for long-term Treasurys. Investors believed the Fed, so they bought Treasurys at those elevated prices. But in the long run, Treasury (and cash) holders lost real value as inflation exceeded yields. Winning the war and becoming the dominant global power made this process less painful.)

2010s Recovery

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Figure 5: EURO STOXX 50 Chart

Unfortunately, the US recovery was not egalitarian. First of all, QE particularly benefits the wealthy because the bottom 50% of Americans barely own any stocks. In contrast, the top 1% own about 50% of household stocks, and the top 10% own over 90% of them. Also, due to globalization and automation, some industrial towns never recovered, and many of the new jobs were based in large cities. More fiscal policy for Main Street may have reduced these inequalities, yet the government held back over deficit concerns.

Meanwhile, the Fed had a hard time reducing its balance sheet and raising rates. Specifically, the Fed wanted to raise rates high enough that it could lower them in a future recession rather than have to do more QE. But a December 2018 increase in the fed funds rate to 2.25–2.50% was as far as the Fed got. Starting in August 2019, it reversed course, cut the rate down to 1.50–1.75% by October, and added T-bills back to its balance sheet.

Raising rates is especially challenging when other countries have even lower rates and in some cases, negative rates. (Japan, which started QE back in 2001, has negative rates, and so do some European countries.) For instance, global stock markets took a hit in 2018 as international investors fled to higher-yielding US Treasurys. In addition, even if the Fed wants long-term Treasury yields to go up, those investors might bid the yields back down.

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Figure 6: Historical Fed Funds Rate

(Aside 5: In September 2019, a minor crisis affected the repurchase agreement (repo) market. If a bank temporarily needs cash, it can sell short-term Treasurys to another bank and promise to repurchase them, usually the next day, at a slightly higher price. This price difference is called the repo rate, which is usually close to the fed funds rate. But due to the Fed’s longstanding attempt to tighten monetary policy, a tax deadline, and a scheduled auction of Treasurys, banks collectively ran low on cash reserves. As a result, the repo rate spiked up to 10% before the Fed intervened by buying T-bills from banks to increase total reserves.)

Part 3: Coronavirus Pandemic and Possible Scenarios

March 2020 Crash and the Fed’s Response

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Figure 7: Historical Unemployment Rate

Faced with these conditions, many investors fled to safety, selling their stocks for cash. Overleveraged hedge funds in particular were forced to sell assets to raise cash. In just one month, the Dow crashed from $29K to $18K, and a rate cut to 0–0.25% plus $700B of new QE failed to stop the slide. Even with the entire Treasury yield curve forced downward, investors continued their selling spree, and on top of that, the corporate bond market froze up.

Consequently, the Fed announced it would perform “unlimited QE” (that is, buy as many Treasurys as it deems necessary to keep markets afloat), and it would buy investment-grade corporate bonds and even junk bonds. Because the Fed cannot legally print money to buy corporate bonds without government-backed collateral, the government had to authorize the Fed’s purchases via the CARES Act, which was passed to help companies get enough funding to stay afloat.

Ultimately, unlimited QE and corporate bond buying drove up the prices and drove down the yields of nearly all assets safer than stocks. Thus, yield-hungry investors collectively decided to buy stocks at higher prices. To put it another way, when such investors sold their bonds for cash, they gave up future yield for present gains. So only when stock prices climbed high enough were they willing to hold the cash instead of invest it in stocks.

As such, the Dow has recovered over half its losses, and the Nasdaq (tech stock index) has hit new highs. Investors have piled into big tech companies in particular because such companies are less hurt by the pandemic and may even benefit from it. As a result, big tech stock prices, such as Amazon and Tesla, have diverged from the prices of most other stocks. Also, some investors, retail in particular, believe that if the market crashes again, the Fed will print even more money. In turn, these investors are engaging in speculative behavior and largely ignoring corporate earnings.

They are also increasingly using apps like Robinhood, which is known for its convenience and for not charging trading fees, to trade options. Options are contracts that give you the right to buy (call option) or sell (put option) stocks at a specific price on a future date, and they are a complex and risky way to potentially make a lot of money in a short time. In particular, Robinhooders are buying call options, which encourages those selling them the call options to buy the actual stocks as protection against a sudden increase in the stock price. That in turn drives the stock prices up. Overall, to help turn investor sentiment over the last five months from risk averse to speculative, the Fed has increased its balance sheet, or asset holdings, from $4T to $7T.

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Figure 8: Fed’s Balance Sheet Since December 2002

(Aside 6: Even though the government only authorized the Fed to buy $75B of corporate bonds, the Fed is indirectly buying up to $750B of them via special purpose vehicles (SPVs). Specifically, these SPVs are using leveraged (in this case, newly-created) money to buy corporate bonds from companies and from the open market. As long as most of the bonds do not default, the government-backed $75B should be sufficient as collateral. The Fed expects it will be sufficient, but there is no guarantee.)

Stock Market vs. the Economy

Nevertheless, the ratio does not have to revert to its historically average level. All a high level means is that if you buy stocks, and future corporate earnings match expectations, then it will probably take more years for future dividends or buybacks to cover your initial investment. (Fortunately, if you need money right away, you can always sell your stocks at the market price.) Ultimately, if investors are content with this arrangement, then the ratio can remain high indefinitely. But based on the March crash, investors most likely would not be content with the current arrangement absent Fed intervention.

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Figure 9: Historical Shiller P/E Ratios

(Aside 7: An anonymous economist makes a very interesting argument that the widespread use of index funds and Exchange Traded Funds (ETFs) in recent decades has helped increase the Shiller P/E ratio. Because any given company can go bankrupt, investing in individual stocks is risky, unless you put in a lot of time and effort to build a well-diversified portfolio. But with an index fund or ETF, you do not have to worry about diversification across stocks. As a result, you may feel safe allocating a higher percentage of your assets to stocks, and if other investors follow, then stock prices and the ratio will go up.)

Inequality, Fragility, and Possible Scenarios

This situation is particularly hard on Main Street’s essential workers, who are helping society withstand the pandemic but mostly not even getting hazard pay. Also, according to philosopher T.M. Scanlon, excessive inequality increases the wealthy’s control over society, corrupts politicians, impedes equality of opportunity, and undermines the social contract between workers and investors. In other words, it damages society even if the poor are materially better off. While these arguments are debatable, I generally agree with them, especially in light of our current social unrest.

In addition, the financial system has become ever more dependent on the Fed. As long as the Fed has everything under control, then this dependency is not an issue, aside from the moral hazard of favoring risk takers over more conservative investors. But if the Fed fails, the consequences could be catastrophic, especially given pension funds’ reliance on the markets. So what, if anything, is the limit to the Fed’s powers? First of all, the Fed may be touting unlimited QE, but all Treasury yields are now near zero. In fact, only 20 and 30-year Treasurys still have yields over 1%. As such, QE on Treasurys has already stimulated the markets almost as much as it can.

Furthermore, before the Great Recession, many people feared inflation would be a limiting factor for QE. Print too much money, and consumer prices will jump, canceling out any increase in nominal wealth. But since the QE money has been largely stuck in bank reserves and the financial markets, it has not inflated consumer prices. In particular, with rates so low, big companies are using borrowed money for stock buybacks rather than stimulative investments. Globalization and improved production technology have also kept consumer and commodity prices down. So given all that, what’s next? Here are three very different possible scenarios:

1. Full Recovery: In this scenario, the economy rebounds from the pandemic before too much damage is done, and the end result is a repeat of the 2010s recovery. Stocks will keep going up, though stock returns might lag behind the historical average, barring a significant improvement economic growth or further increases in P/E ratios. Then again, there is no limit to how high stock prices can go, and bullish sentiment can be quite powerful. Meanwhile, interest rates and Treasury yields will slowly normalize, and Main Street will do better over time.

But Main Street has fallen very far, which means its recovery will likely be a slog that fails to match the pace of Wall Street’s. Inequality will remain high, and socioeconomic tensions may remain high as a result. The stock market seems to be pricing in this scenario (corporate earnings as we emerge from the pandemic will be a good indicator of its likelihood), but given the system’s fragility, there is no guarantee that it will materialize. Furthermore, if another crisis occurs in the future, we may be back at square one. Only time will tell if we are in fact in the clear.

2. Liquidity Trap: Alternatively, the economy may suffer continuing setbacks, such as a longer-than-expected pandemic, cascading defaults and bankruptcies, or further hits to corporate earnings. So unemployment may stay high for a long time, and the economy may fall into a deflationary depression. If so, QE may not work as well it used to, as investors who sold their bonds may hoard cash rather than buy stocks. More precisely, once-speculative investors may turn risk averse and allocate a greater percentage of their portfolios to cash, even with rates stuck at zero. Keynesian economists call this phenomenon a liquidity trap. Then with fewer buyers of stocks, sellers will take profits, causing the market to decline again.

Also, with QE not working as well, the long-term stock market recovery may take years like Europe’s in the 2010s. In theory, the Fed could start buying stocks, but it would need government authorization to do so, which may be politically unpalatable. The Fed could also make the fed funds rate or even Treasury yields negative, but negative rates have not helped much in Europe because savers can avoid them by stuffing cash under their mattresses. Having said that, the Fed is doing everything in its power to avert this scenario, and stock investors are showing no sign of demanding a higher risk premium.

3. Inflation: Lastly, if the Democrats sweep the 2020 elections, they may pass multi-trillion dollar debt-financed fiscal stimulus packages. In particular, a now-popular economic school called Modern Monetary Theory (MMT) argues that as long as stimulus money is used productively (for example, guaranteed jobs for infrastructure or a Green New Deal), inflation will remain controlled, as the new dollars will chase more goods. (This argument does rely on a stable velocity of money.) Ultimately, if such stimuluses help Main Street, reduce inequality, and do not run up inflation, then the Fed and the government will have pulled off a historically impressive collaboration.

But there is a fragility risk: if the government is such a large driver of the economy, its mistakes will be amplified. So if the stimuluses are less efficient than hoped, inflation may finally pose a problem (though not to debtors who will welcome any devaluation of their debts). Potential supply shocks, such as post-pandemic deglobalization, or a shift away from the dollar as the global reserve currency may also induce inflation. (Though other central banks are easing too, so there is no clear replacement currency.) We can already see investors anticipating a combination of inflation and artificially low yields by bidding up gold to record highs.

Per MMT, if the government wants to fight this inflation, it can raise taxes to take money out of circulation. However, raising taxes exclusively on the wealthy may not be very effective against inflation, and the government may lack the political will to raise taxes on all Americans. Alternatively, the Fed can raise rates, which should stop the inflation. (MMT does not endorse rate increases; rather, it calls for perpetual 0% rates.) But higher rates are bad for stocks and bonds because with savings accounts paying interest again, investors will dump assets for cash. It will also be hard for the government and the Fed to strike the least-bad balance, as there will be a lot of uncertainty about how stringent anti-inflation measures should be.

Conclusion

But I will say that for the financial system on the whole, there are no simple solutions. I believe the Fed (and international central banks) should have pulled back on monetary policy in past decades to give themselves more ammunition for a future crisis, but tightening now would result in inordinate financial and economic pain. Then again, some argue that the Fed is only postponing that pain and transferring it from the wealthy to the poor. Future events will reveal how wise the Fed’s decisions have been.

Nevertheless, while the Fed might have made the right decisions, I do not support the way the Fed and the government have interacted. In my opinion, if the Fed intervenes to prevent the markets from crashing, then the government should intervene just as much to help Main Street. There are arguments in favor of hands-on and hands-off approaches, but Wall Street should not benefit while Main Street suffers.

I write about economics.

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