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Will The Circle Be Unbroken?


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This week, famed investor Stanley Druckenmiller said this regarding the Federal Reserve (the Fed), “The Fed has no endgame and the end objective seems to be preventing the S&P from having a 20% decline.”

The only thing that I would omit in that statement would be the “seems to be” part. I think that is exactly what The Fed’s objective is. The tone of the equity markets is essential to keeping a bizarre circular loop going between equities and the corporate bond market. Let’s think about what exactly is going on between the corporate bond market and the stock market. Here are the steps,  but, first a warning. This is a circular loop, so it is impossible to say where the beginning and ending points are.

  1. The stock market shows a positive tone.

  2. The investment grade new issue market responds favorably to that positive tone in stocks and issues new bonds at historically low yields.

  3. Purchasers of those bonds, many of whom have to buy something with at least the semblance of a positive yield, snap the bond up as their confidence is raised by the positive tone in the equity markets.

  4. The corporations take much of the new money they have borrowed and buy back stock (“borrowing from the future,” as Mr. Druckenmiller also said).

  5. The corporations buying back their own stock with borrowed money make the equity market feel better about itself, so it maintains its positive tone. This good feeling helps the beleaguered high-yield corporate market feel better, too.

  6. The continued, positive tone in the equity markets allows for steps two, three, four, and five to be repeated over and over again.

I am not a conspiracy theorist, and I don’t think that Janet Yellen, or any of the Federal Reserve governors, are part of a cabal acting on orders to make the wealthy wealthier and the poor poorer. However, I think that the Fed has seen just how very fragile the financial markets are, and I think they know that a financial crisis could lead to an economic one, one with which they have very little ammo left to fight. Through the Fed’s seven years of Zero Interest Rate Policy (ZIRP) and Quantitative Easing (QE), a huge percentage of the American public has, unwittingly, some might say, , invested corporate bonds like they have never done before. The public has invested in corporate bond funds after being essentially kicked out of safer investments like the government bond markets because of the Fed’s twin monetary policies. I think it is safe to say that much of the public underestimates the risk of their new investments.

Last winter, when the open-end mutual fund, Third Avenue Focused Credit, failed and essentially closed its doors to investors trying to pull their money out, the Fed saw a horrible potential problem. While Third Avenue was an extreme case, (with almost all of their investments in CCC-rated corporate debt) the Fed saw that for many large bond funds, the liquidity position of the funds did not match their risk profile. Furthermore, the Fed got a very big glimpse into how sparse the liquidity provided by the dealer community was, when risk markets went bad. In 2008, a “run on the bank” in the form of money market mutual fund investors trying to redeem their shares, and who were turned away, almost caused the collapse of the entire financial system. The Fed and Treasury stopped that run by backstopping the funds. I think the Fed sees the real possibility of this happening again with bond funds, and the results of that would be catastrophic for the financial markets as well as the economy.

 I think the Fed is keenly aware that the global financial markets are in perilous shape, and they have to keep the above-mentioned circle going as they hope and pray for something to spark real demand and real economic growth. The question is, can they keep it going before they run out of time?

Member SIPC & FINRA. Advisory services offered through SWBC Investment Company, a Registered Investment Advisor.

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