Keith Hembre dumped bonds and bought stocks when the Federal Reserve announced its plan Nov. 3 to buy $600 billion of Treasuries. The rationale: to benefit from anticipated market gains on days of Fed purchases.
The chief economist and investment strategist at FAF Advisors Inc. may be on to something. Most of the 47 percent stock rally during the past two years came on days when the Fed pumped money into markets through bond buying, according to data compiled by Bloomberg. Since the $1.7 trillion first round of quantitative easing began on Dec. 5, 2008, the Standard & Poor’s 500 Index of stocks has climbed a combined 267 points on the 212 days when the Fed was adding stimulus, compared with 128 points on the 297 days when it wasn’t.
“We took action,” said Hembre, who helps manage more than $86 billion at the unit of U.S. Bancorp in Minneapolis. “The primary benefit of quantitative easing ends up supporting the price of riskier assets, not necessarily that of Treasuries.”
The data may bolster Fed Chairman Ben S. Bernanke’s assertion that his asset purchases are inducing investors to buy higher-yielding securities, even though the central bank’s dollars don’t go directly into the stock market. Fed officials are counting on the second round of quantitative easing to jumpstart an economy that’s plagued by too-low inflation and an unemployment rate near 10 percent.
Some investors see a “conspiracy theory” that the central bank causes a stock rally on days of its purchases, Bank of America Merrill Lynch strategists led by Jeffrey Rosenberg said in a Nov. 2 report. While the report showed stocks rose on 15 of the 24 days the New York Fed bought Treasuries from Aug. 17 through the beginning of last month, Rosenberg said he’s skeptical of a direct relationship because of positive economic indicators on some days.
The data compiled by Bloomberg show the S&P 500 gained an average of 0.16 percent on buying days during the past two years, four times the 0.04 percent on non-purchase days.
Bernanke has never publicly drawn a connection between the stimulus and the stock market’s daily fluctuations. The Fed chief, who convenes policy makers tomorrow in Washington for their last meeting of 2010, discussed the correlation only in general terms last month. The Fed’s program “looks to be effective” because share prices rose and long-term interest rates fell when investors began to anticipate a second round of purchases, Bernanke said in a Nov. 4 Washington Post opinion piece.
‘Assume More Risk’
“I’ve yet to notice any black helicopters flying outside the New York Stock Exchange, but one of the reasons you have quantitative easing, of course, is to compel investors to assume more risk,” said John Lonski, chief economist at Moody’s Capital Markets Group in New York. “This increases the supply of financial capital to the private sector, with the possible consequence of boosting the economy.”
Stock-market gains help fuel growth through the so-called wealth effect, or the tendency of consumers to spend more when their assets are appreciating in value, Lonski said.
Nine of the S&P 500’s 10 main industry groups, led by shares of financial companies, rose more on days when the Fed opened its checkbook for, or announced results of, what it calls Permanent Open Market Operations. The group of 81 banks, insurers and investment firms, including New York-based JPMorgan Chase & Co. and Wells Fargo & Co. of San Francisco, climbed an average 0.32 percent, compared with a 0.04 percent drop on non- POMO days.
FX Concepts LLC, the world’s largest currency hedge fund, buys higher-yielding assets such as stocks and the Australian dollar when the Fed is purchasing bonds, said John R. Taylor, who manages about $8 billion as chairman of the New York-based firm. The days have become “incredibly important for the market,” Taylor said.
The Fed’s purchase program, known as quantitative easing, works by increasing the quantity of bank reserves in the system. Policy makers direct the markets desk at the New York Fed to buy government securities from primary dealers, or brokers who are authorized to trade directly with the central bank, adding funds to the dealers’ accounts and creating reserves at their clearing banks. Financial firms were parking $979 billion of reserves at the Fed in excess of requirements as of Dec. 1, earning 0.25 percent interest.
‘Portfolio Balance Channel’
The central bank’s buying helps the economy through the “portfolio balance channel,” as investors replace Treasury securities with other types of assets, Bernanke said in an Aug. 27 speech in Jackson Hole, Wyoming.
Not all investors subscribe to the idea that the Fed’s bond purchases inflate stocks on a given day. Historical data are limited, and the rally since July is “closely correlated” with other news, such as economic and earnings reports, said James Paulsen, chief investment strategist at Wells Capital Management in Minneapolis, a unit of Wells Fargo.
“I’ve had a problem with people focusing so much on what the Fed’s doing, as though that’s dictating everything that’s happening,” said Paulsen, who helps manage more than $300 billion.
Bank of America Merrill Lynch’s Rosenberg, who found shares outperformed on days when the Fed was buying, also cites economic data for the increases. “Correlation doesn’t equal causality,” said Rosenberg, head of global credit strategy in New York.
Rising Retail Sales
Some signs point to a U.S. recovery gaining steam, even though unemployment has remained at 9.4 percent or higher since May 2009. Sales at U.S. retailers jumped in November by the most in eight months, manufacturing expanded for a 16th consecutive month and consumer confidence increased in December to a six- month high.
The S&P 500 index rose last week an average 0.17 percent on the four days with Fed purchases; it gained 0.6 percent on Dec. 10 with no central bank buying to close at its highest level since September 2008. Today stocks erased gains in the final hour of trading, leaving the index up 0.06 point at 1,240.46 at 4 p.m. in New York.
FAF Advisors’ Hembre, 43, a former Minneapolis Fed researcher, disagrees with the naysayers. “You see substantial outperformance of risky assets,” he said. The Fed’s money, “while sort of directly being put into the Treasury market, gets reallocated to the folks putting risk on.”
Treasury prices, by contrast, fell on average during the past two years when the Fed bought securities. The yield on the benchmark 10-year note climbed an average 0.6 basis point, based on Bloomberg generic yields. A basis point is equal to 0.01 percentage point.
That may be explained by investors adding more risk and anticipating faster growth, Hembre said. Equities are likely to benefit in the next several months as the Fed adheres to its plan to buy Treasuries through June, he said.
The Fed might even expand bond purchases beyond $600 billion, Bernanke said in an interview broadcast Dec. 5 on CBS Corp.’s “60 Minutes” program.
The central bank’s actions have been criticized by Kansas City Fed President Thomas Hoenig and Ohio Republican John Boehner, the presumptive U.S. House speaker, for their potential to stoke inflation or fuel asset-price bubbles.
‘Propping Up Stocks’
The Fed is “basically propping up stocks,” said Nicolas Lenoir, chief market strategist for ICAP Plc’s ICAP Futures LLC in Jersey City, New Jersey. “You should have good economic stats driving stocks up. The transmission of the wealth you create from stocks into real economic activity doesn’t work.”
This isn’t the first time traders have hypothesized about the Fed’s impact on share prices. Some investors in 1999 attributed a stock rally to backup liquidity programs policy makers started because of concerns about computer-software problems when the year 2000 began, said Scott Pardee, who worked at the New York Fed from 1962 to 1981. The S&P 500 returned 15 percent in the last three months of 1999, the majority of its 20 percent gain that year.
“The Fed has no intention of manipulating the market,” said Pardee, 74, who was senior vice president and manager for foreign operations of the Federal Open Market Committee from 1979 to 1981 and now teaches monetary economics at Middlebury College in Vermont.
He had a brush with the issue personally. Some bond traders confronted Pardee in the early 1980s at a party on a wharf by the East River in Manhattan after the Fed released bigger-than- expected monetary aggregate numbers one week, indicating interest rates were likely to rise, he said.
The traders “started arguing about why the Fed was manipulating the money supply so much,” Pardee said. “I was afraid they were going to throw me in the river.”
The central bank now is causing investors to hunt for yield by boosting demand for low-risk assets such as Treasuries, said Jeffrey Saut, chief investment strategist at Raymond James & Associates in St. Petersburg, Florida.
“If the ATM is spitting out $20s, you are more likely to take the money to the track than the mattress,” Saut said.