December 18, 2013

The Short Fed Story

Is the Federal Reserve fueling stock-market gains?

When St. Louis Fed president James Bullard addressed the Bowling Green, KY, Chamber of Commerce in February 2011, he pinpointed correlation between Ben Bernanke’s September 2010 Jackson Hole speech on “QE2,” the Fed’s second easy-money program, and the stock-market rebound that followed. Classical effects of monetary easing include rising equity prices, Mr. Bullard said.

The Fed wanted market appreciation because people feel better when the stuff they own seems more valuable. But I think we’re having the wrong debate. The question isn’t if Fed intervention increases stock prices, but this: Can prices set by middle men last?

Before actor Daniel Craig became the new James Bond he starred in a caper flick called Layer Cake that posited a rubric: The art of the deal is being a good middle man. The Fed is the ultimate global middle man. Since the dollar is the world’s reserve currency, the Fed as night manager of the cost and availability of dollars can affect everybody’s money. After all, save where barter still prevails, doing business involves money. Variability in its value is the fulcrum for the great planetary teeter-totter of commerce. The risk for the Fed is distorting global values with borrowing and intermediation.

In the stock market, we’re told it’s been a terrible year for “the shorts” – speculators who borrow shares and sell them on hopes of covering at a lower future price. The common measure is short interest, a twice-monthly metric denoting stocks borrowed, sold, and not yet covered. Historically, that’s about 5% of shares comprising the S&P 500.

But as I’ve explained before, short volume, trades marked short rather than long because the shares behind them were borrowed for the day, consume over 40% of the 6.2 billion shares trading daily in US equity markets. That’s 2.5 billion shares, largely missed in short interest. Shares are borrowed through margin accounts. The top providers are the Fed’s primary dealers, the Too Big to Fail Banks. Market data indicate that nearly 90% of volume – 5.5. billion shares – flows through 30 firms, half big brokers including Morgan Stanley and Goldman Sachs, the other half high-speed traders like Hudson River Trading and Quantlab Financial.

Traders renting shares aren’t investing; they’re profiting on logistics, moving things around. Setting prices without committing resources is shilling – bidding on something you don’t want to own.

The Fed too shills and borrows by intermediating prices in financial markets and swelling its balance sheet. These policies depress the cost of capital near zero, distorting asset prices and risk-taking. Saving money, a prudent endeavor, offers no return. Everyone must act on the Fed’s intermediary efforts to drive up the value of assets. No investment is “risk free.” When risk-free rates are normal, about 6% in modern history versus about zero now, it makes little sense to borrow for a day. But with daily borrowing rates near 0.20%, and intraday volatility – spreads between high and low prices of stocks – around 2%, borrowing is rampant.

Middle men like the Fed and fast traders can support and inflate prices for periods through borrowing, so long as real prices and shill bids are hard to distinguish. What if the shill bidder leaves, as the Fed now must contemplate with so-called “tapering,” or reducing its monetary support for the two pillars of global value, US-government borrowing and mortgage-backed securities? The Fed is the ultimate planetary middle man. We don’t know the real value of money, let alone the assets money denominates.

Maybe the art of the deal hinges on a good middle man. But pooled real capital deployed at fair return rates is a time-tested path to durable wealth – and this isn’t it. Value in stocks and the economy alike rests on middle men. That makes me uncomfortable, to say the least.

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