U.S. financial markets have been increasingly skittish in advance of the Federal Open Market Committee meeting scheduled for Wednesday June 19. Will the Fed or will it not begin to taper its $85 billion monthly purchase of Treasury and federal-agency bonds? When eight males and four females meet to determine whether an extended exercise in socialism will end or will continue, millions of individuals fidget with their wealth portfolios. Traders around the world, who in better free market times considered a wide range of variables, now focus on a single one, Federal Reserve policy.
In bygone days of free markets, stocks tended to move counter to bonds as investors switched from one to the other in order to maximize yield. But in the new world of Bernanke-rigging, they often head in the same direction. That is not good for investors or for capitalism.
Bondholders surely expect bond prices to fall and yields to rise if the Federal Reserve removes its socialist prop. However, they also worry whether the 15,000 Dow may be a Bernanke bubble that will also deflate as the Fed taper begins. Let us follow the money to see how this may occur.
The Fed makes its Treasury bond purchases from the primary ‘dealer’ banks. The proceeds boost the banks’ deposits at the Fed far in excess of legally required reserves. To encourage the banks to hold this base money sao that it will not entrer the credit markets and destroy the value of the dollar, the Fed pays the banks a quarter of a percentage point interest on their deposits.
But it is far from easy to contain $2 trillion in inflationary cash. Many analysts believe that excess deposits are a direct factor in the run-up in stocks since March 2009. Banks have constant dealings in the shadow market with non-bank entities, like money-market, hedge funds and other big money pools. It is a short stretch to imagine these institutions accessing excess bank reserves as collateral to raise money for stock market speculation. Margin debt at the New York Stock Exchange reached a record high of $384 billion in April 2013 – and that means that the stock market is receiving heavy support from borrowed money.
If the Committee of Twelve decides to pull the plug tomorrow, watch out for significant declines both in bond prices and in the Dow and the S & P 500. The enormous quandary now confronting the Fed is a direct consequence of the constructive rationalism of Ben Bernanke and his colleagues at the Fed. Like all socialists, as Friedich von Hayek observed half a century ago, their fatal conceit now threatens the green shoots of a fragile economic recovery.
Hat Tip: George Melloan, ‘How the Fed Turned the Market Skittish’, The Wall Street Journal, June 18, 2013