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Investing in the equity or debt markets in the world with greater levels of Central bank interventions –

The rebounds of the market – seems to be responding to the Fed and the US Treasury

  1. Last week – the ASX recorded its biggest one-day rise in two months – the market hit the 6,130 mark and then took a tumble – went down to close to 5,700 – then rebounded – this rebound seemed to be after an escalation in policy support from the US Federal Reserve was announced
    1. In one day -the S&P/ASX 200 Index surged 222.5 points – or just under 4% – biggest one-day gain since early April
    2. This brought an end to the start of a sell-off trend – previous 3 trading days reduced the market y 7% – since then been hovering around the same level
  2. This episode is to explain why this is the case – and how the Central Bank involvement in the markets going forward can sharp large rebounds in the markets – and provide a false confidence for investors – especially those with an appetite for shares and assets higher up the risk curve

To start with – think of the market at the moment as a ball on a hill –

  1. The hill itself is the potential for upwards and downwards movements of a ball – The ball itself is the price of the market
  2. Someone kicks the ball up – it going up – loses pace and then starts to roll back down – but then the Treasury and the Fed are standing there ready to kick it back up – and repeat this process – how?
  3. Expanding their powers to get further involved in the share market – or the game of kicking the ball – through The purchasing of corporate bonds
  4. Last week – the Fed said it would begin buying corporate bonds directly off the market – this is one of the more significant policy developments from the central banks since QE was introduced in 2009
    1. The intention to expand asset purchases to include corporate bonds was first unveiled by the Federal Reserve at the end of March – officially implemented for the first time at an expanded capacity last week
  5. I covered this topic though back in February – in an episode called “What Central Bankers may do in the next financial collapse” – although the central bank was yet to put the plan into action at that time – it was just simply paying attention to what they were saying they were going to do –
  6. Previously under QE – The problem for the Fed alone is that it is only allowed to purchase or lend against securities with government guarantees
    1. these are assets like Treasury securities, agency mortgage-backed securities, or debt issued by Fannie Mae and Freddie Mac – why the Fed was allowed to buy back the worthless MBS off investment banks back in 2008/09
    2. But they can’t buy any equity or debt in companies – which would be a form of government sponsored funding mechanism for companies –
  7. However – now The Fed is bypassing the banks or asset managers to inject money into the financial system – now they are lending directly to the private sector through the purchase of their debt
    1. The Fed will now start to buying private debt, directly from companies as they go to market to raise capital and as existing bonds and other securities are offered on secondary markets
    2. The additional assets that can be purchased – this includes municipal bonds, non-agency mortgages, corporate bonds, commercial paper, and every variety of asset-backed security
      1. The only things the government can’t buy are publicly-traded stocks and high-yield bonds
    3. Companies have two ways of raising funds – Through equity (more shares) or debt (bonds and notes) – the cost of this is what is important to valuations – come back to this in a minute

How is this all being done –

  1. The Fed is not just buying secondary issuance – but primary issuance through a special purpose vehicle – Covered the SPVs in the episode – Crony capitalism and Modern Monetary Theory in action!
  2. What happened – the Treasury created a series of special-purpose vehicles (SPVs)
    1. A special-purpose vehicle (or entity) is a legal entity created to fulfill narrow, specific or temporary objectives. SPVs are typically used by companies to isolate the firm from financial risk – it is how property developers work with each single development – limits liability into one single entity
    2. The aim of these is to buy all manner of financial assets, backed by $425 billion in collateral conveniently supplied by the US taxpayer via the Exchange Stabilization Fund.
      1. an emergency reserve fund of the United States Treasury Department, normally used for foreign exchange intervention
    3. The Fed will lend to SPVs against this collateral which, when leveraged, could fund $4-5 trillion in asset purchases of additional assets beyond what the Fed itself could access in its mandate.
    4. Round about way for the Fed to circumvent their mandates – as even though the assets inside of the SPV may not have government guarantees, the SPV itself can
  3. In QE – the Fed moves assets onto its own balance sheet – Under a SPV – the Treasury will now be buying assets and backstopping loans through SPVs that the Treasury will own and control
    1. Backstopping is a practice of purchasing assets if nobody else is demanding them
    2. SPVs are a form of shadow bank – create money by “monetizing” debt or turning it into something that can be spent in the marketplace – injecting liquidity back to the sellers of these debt instruments
    3. So the SPV decides what assets to buy and borrows from the central bank to do it.
      1. central bank then prints the money – which are used to purchase the assets backing the loan
    4. In other words, this is a step towards the federal government nationalizing large chunks of the financial markets and companies listed on them – so now, the Fed is providing the money to the Government to buyout large sectors of the financial markers, whilst having BlackRock doing the trades
    5. The purpose of this – Looking at the SPVs – none technically serves a purpose beyond buoying the markets

 What are the effects of this on the markets –

  1. Listed companies have two ways of raising funds – Equity or Debt –
    1. Equity is capital raisings – issuing more shares to raise money
    2. Debt is issuing bonds or capital notes in the company –
  2. The central bank intervention pushes the cost of debt and equity down in the world’s largest capital market, which in turn lifts the value of shares relative to other lower-risk assets such as bonds
  3. In Australia – The RBAs policy program is narrower than the Fed’s, Australia’s central bank struck a similar tone of unqualified support at its last monetary policy meeting
    1. From the meeting – RBA’s commitment to keep funding costs “as long as required” – this has added to the liquidity-fuelled rally on the ASX

Why does this matter – Beyond the fairly evident intervention into markets – propping up prices through affecting valuations – how is this done

  1. When it comes to the valuation of companies – FCC over the WACC
  2. WACC – Debt and equity costs of operating – used in the denominator of an equation
  3. If the debt costs of operating are low – the WACC is also low – so then the valuations of the business can rise – even without raising the FCC of a firm – the FCC of a company can drop but the valuations can rise –
  4. So if the Fed – or other central banks start bailing out these large companies – remember there is around $72trn of Corporate debt floating around – $19trn of this is owned by companies that cant generate enough revenue to make the interest repayments –
    1. Large concern to investors is that companies have too much debt – so their costs are high and if revenues fall slightly – that is game over for the company – therefore there can be a sell off of the shares
    2. Also – if the existing investors in the debt market get worried about this – they may sell of their bonds in the companies – which would lower the price but raise the yields/i.e. the servicing costs of the debt – which could also wreck a company – to avoid this – Treasury can buy up any excess supply
  5. Naturally – some of the largest recipients of this – are the Financials – and other industries with heady debt burdens
    1. The index-heavy financials sector accounted for close to a third of the rise in the combined value of the ASX 200 shares, with lenders among the primary beneficiaries of central bank liquidity.
    2. ANZ rose 4.5 per cent to $19.23, Commonwealth Bank added 4.2 per cent to $69.09, National Australia Bank climbed 4.1 per cent to close at $18.85, and Westpac advanced 4.1 per cent, ending the day at $18.09.
  6. In addition – the correlation of markets means that if this is done in the US – and their markets rebound – our markets prices will be affected
    1. At this stage – these SPVs are just being used to backstop the market – but In essence but also as a long-term effect, the Fed is giving the Treasury access to its printing press which is what is the worry in the long term, as the issue I see in the long term is that all of this gives Governments more control over the economy – and the supply of money
    2. Long term – this has the potential to create a socialist monetary state – gives the printing press needed for funding Universal Basic Incomes – and once these powers are in place – any future administration can look at implementing these policies
    3. Going further – Congress could designate a Special Purpose Vehicle to fund its infrastructure projects – or other public services that need a printing press – including Medicare for all, a universal basic income, student debt relief, and similar programs.
    4. It could also use the funds to purchase a controlling interest in insolvent or profligate banks, pharmaceutical companies, oil companies – nationalising these companies
    5. Another possibility would be for Congress to fund these programs in the usual way by issuing government bonds, but to enter into a partnership agreement first by which the central bank would buy the bonds, roll them over indefinitely, and rebate the interest to the Treasury.
    6. That is how Japanese PM has funded his stimulus programs – was in an aim to get inflation – but the Japanese consumer price index is at about 0.4% – the more of these policies that went on – the lower it got
      1. At this stage – the Bank of Japan has monetized nearly half of the government’s debt.
    7. What this is all about – the share market harnessing the power and endless printing press of the central banks – Especially in the USA
    8. If this continues to play out – whilst the ball may want to roll to the bottom of the hill – the Fed and other central banking officials will be there ready to kick the ball back up until it loses momentum again
      1. Rinse and repeat – but this doesn’t create a better market – but a more fragile one built on debts –
      2. Companies to be bought – those with natural demand for their products –
      3. Skews incentives – for large companies to become further zombified – taking on larger debt levels as they know someone will always be there to purchase it – and as long as these SPVs continue to be a backstop – companies wont be punished
      4. But is playing a dangerous game – as with one announcement – the markets can tank
      5. Delaying the inevitable

Thank you for listening to today’s episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/

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