For some strange reason, humans will look at two lines moving in the same direction and think that one causes the other. While this simple way of linking causes with their effects can work, more often than not, it doesn’t!
The chart below has to be one of the most famous, and circulated, charts of the past decade.
Countless people have observed that both data sets dovetail nicely in an upward trajectory, and come to the conclusion that the stock market is rising because of the Fed’s massive expansion of bank reserves.
However, what they don’t know is that QE is nothing more than a right-pocket-to-left-pocket asset swap.
Putting it another way: No money was created in this transaction.
The premier form of money used in the financial system, US Treasuries, was taken out and replaced with bank reserves, a form of money that can only be used by banks and no one else in the wider economy.
Bank reserves are used by banks to settle transfers between themselves on behalf of their customers like you and me. While this is, without doubt, an extremely important economic function, it has no direct bearing on the equity markets.
This is because bank reserves very rarely make it to trading accounts that purchase stocks (like asset managers or individual traders).
Bank reserves sit on the balance sheets of banks… and stay there.
But why can’t banks purchase stocks directly?
Surely because of the correlation that has to be what is happening?
Banks will not purchase stocks (or for that matter fixed income instruments deemed to be “risky”) for the same reason any well managed corporation will not purchase stocks with their cash balances* – they are NOT in the business of speculating in equity prices!
Banks are in the business of banking, just as McDonald’s is in the business of serving fast food. McDonald’s doesn’t invest its cash balances into stocks, so why would banks?
It also isn’t a matter of “McDonald’s isn’t involved in finance and can’t understand markets”. It is however, a matter of not taking excessive and needless risk with what is ultimately, shareholder’s money. (It must be noted that Tesla is a notable exception, with the company investing in Bitcoin)
Over the years, it has been possible for some amount of the Fed’s liquidity to end up in fixed income markets, and possibly (although unlikely), even equity markets. If the Fed purchased Treasuries and/or Mortgage Backed Securities directly from asset managers instead of through the primary dealers (banks), the asset managers would have reinvested the proceeds back into the markets.
However, most of QE has been transacted through the primary dealers, which means bank reserves stuck on bank balance sheets.
No torrents of liquidity flowing into equity markets then. But if this isn’t the case, why is “QE juices stocks” such a popular narrative?
The first reason would be the obvious one, a simple misunderstanding of what QE is and is not, how the Fed transacts the programs, what bank reserves are and are not, how the financial system works in reality, etc.
The second, and much more powerful reason, is paradigm. Market participants have been trained too well, since the days of Greenspan, that when the Fed says its programs and policies support markets, that’s actually what happens.
They believe that the Fed will achieve what it says its policies are supposed to achieve, because that is how the Fed says the system works, and that is how the textbooks say the system works.
Since paradigm is the deepest and most difficult part of a complex system to change, every new episode of QE results in the same manic bidding up of all risk assets.
Correlation really doesn’t equal causation. In the case of QE and stocks, given the outsized influence a complex system’s paradigm has on its future paths, what happens when the paradigm switches from belief to disbelief?
*Corporations can and do purchase stocks when they are looking to take minority stakes in other companies, but this is a business decision, not a “let’s buy stocks to earn more yield on our cash balance” decision.
Here is another famous chart, circulated widely around financial circles ever since the modern Fed first employed QE in 2009.
The chart shows gold prices soaring along with massive increases in bank reserves, the idea being that the Fed’s massive “money printing“ has led to the debasement of the USD relative to gold.
How true is this?
The debasement narrative runs further, with gold touted as the haven against “inevitable” inflation (some go so far as to suggest hyperinflation), as well as the “ineluctable” destruction of the dollar.
Unfortunately for those who have bought into this narrative, it simply is not true, because QE does not work in the way they think it does.
For the debasement narrative to work, there has to be an increase in money supply in the economy. The narrative rests on the belief that this increase comes about from all the reserves that the Fed has printed to pay for its QE purchases.
As we now know, those reserves are stuck in the banking system. Bank reserves are not lent out, which means the reserves that were printed into existence because of QE do not enter the economy.
As such, money supply in the economy has not skyrocketed in the way people believe it has.
Supporting this is the fact that inflation has failed to materialize in any sustained, meaningful fashion, much less in a manner needed for hyperinflation.
Furthermore, money velocity in the States is at abysmally low levels, which makes one wonder: if velocity is at multi-decade lows, and money supply isn’t growing because QE does not work, what kind of broad based inflation is there to be had?
Additionally, the lack of money supply growth in the economy also means that the USD has not been debased into destruction.
This is because, 1) QE is nothing more than an asset swap where no new assets are created, and 2) the reserves that the Fed swaps for USTs (and MBS etc) are stuck on bank balance sheets and cannot be circulated in the economy.
In fact, the lack of USD debasement is clearly demonstrated by the dollar’s upward trend against a broad basket of currencies ever since QE1 in 2009.
Why then does gold keep moving higher with each iteration of QE?
Because of Paradigm. Everyone believes that QE = printing money, and acts accordingly. It doesn’t matter if the narrative is erroneous, it only matters that people believe in it*.
Add into the mix a good dose of FOMO, people mistaking correlation with causation, and the spark of QE is lit on the kindling of misunderstanding.
*There are those who think in the opposite way, that QE is evidence of policymakers’ failure, but still end up buying the precious metal anyway – as a hedge against the government.
QE has been a popular reason cited for the rise in cryptocurrencies.
But we know that QE doesn’t work and reserves don’t reach the broader population, so what is happening?
Another popular reason cited for cryptos’ rise in price and popularity is that the low yield environment created by central banks has forced investors to move into ever more risky assets in order to earn some kind of meaningful return.
This does have a ring of truth to it, after all interest rates are at historic lows and investors are pushing into assets they would have previously classified as “too risky”.
However, this does not take into account the fact that cryptos began as, and at this point continue to be, an asset that is primarily held by individual investors.
Individual investors simply do not have the same kind of access to the financial markets as professional money managers do.
Even if they did, very few have the time and resources to not just educate themselves on the subject matter, but also to be involved in markets to an extent where they gain enough experience to properly understand how everything works.
Consequently, individual investors think of investing very differently from institutional ones.
The primary consideration for most is how much interest they earn in their bank accounts; those who are more adventurous venture into stocks and/or real estate.
From this standpoint, would individual investors move into crypto assets because their banks are paying pitiful interest rates?
Possibly, but there is another way to look at it, which is that investors who have relatively low levels of capital tend to be more willing to jump at opportunities to make a quick buck.
Consider the reality:
An asset manager with $100 billion in assets, who owns a “safe” portfolio in this age of ultra low rates which yields 1%, will generate $1 billion.
For an individual investor with $100,000 in savings, that same portfolio will generate just $1000, which, obviously, will not have much impact on the individual’s life.
Absolute amounts matter a lot more for individuals than they do for institutions; it’s money that can fund the purchases of cars, houses, holidays, college tuition for kids, etc.
Hence, individual investors rarely think of yields in the same way financial institutions do, simply because the absolute amount they earn in interest income doesn’t really move their financial needle.
They don’t buy cryptocurrencies because their banks are paying low interest rates, they buy cryptocurrencies because they think their investment will net them a large multiple of profit – an amount large enough to change their lives.
As such, to the individual investor, owning crypto really isn’t about yields.
For better or worse, it’s about the hope and potential of making a life changing amount of money which allows them to break out of the wealth inequality trap that QE has exacerbated.
To be continued…
There is, of course, an even more important driving force behind the mind-blowing rise in the values and popularity of crypto assets – some investors actually believe in it.
Even then, QE has had some role to play in crypto’s meteoric rise… it just isn’t what everyone thinks it is.
The narratives that mainstream commentators have constructed around crypto focus on conventional economic views and thinking, erroneously brushing off crypto price moves as unintended consequences of central bank action.
Because of this central-bank-centric worldview, such commentary fails to see that crypto assets could actually be worth something to someone. Here, QE, bank reserves, and low interest rates have absolutely nothing to do with crypto’s value.
First of all, anything can be an asset, simply because anything can have value, even if it has little to no actual use. All that is needed is for enough people to believe that it has value and hence be willing to pay money to own it.
Yes, it is all about Paradigm again.
Similarly, the biggest (and loudest) criticism of crypto assets is the consequence of holding on to a different paradigm. Those who consider cryptocurrencies to be worth nothing because of their lack of intrinsic value are simply folks who firmly believe in the notion of assets needing to have value in and of themselves.
Because they cannot, or choose not to see perspectives that lie outside of their paradigm, they cannot see things from the crypto believer’s standpoint.
Through the eyes of the true believer, cryptocurrencies represent independence from a financial system that is built on flimsy fiat foundations. With this as the foundation of their worldview, it is only natural that they would seek an alternative asset with which to reduce their exposure to fiat currencies.
This leads us to where QE has had an effect on crypto, which is also, ironically, what both camps can agree on.
However, and even more ironically, their agreement is based on a common misconception of what QE is and does!
Broadly speaking, both camps are big believers in the narrative that QE = money printing; and therefore jacks up equity prices, gold prices and crypto prices, while grossly debasing the USD.
They aren’t, and are stuck on banks’ balance sheets.
Which means that the most likely effect QE has had on crypto markets is to increase the number of crypto buyers who are buying because of a false belief!
And therein lies the irony – who is doing whom a favor here?
The mainstream non-crypto believer driving up the price of crypto assets because they believe the Fed leaves them no choice, thereby enriching crypto believers in the process?
Or the crypto enthusiast who is providing these “fiat refugees” with a crypto safe haven away from fiat insanity?
In this mad world where even the people in charge don’t understand what they are doing, who really knows?
Do low rates lead to higher stock prices?
Or is this a case of correlation ≠ causation?
A common argument used to explain the link between low rates and roaring equities is that low interest rates mean higher present values, and therefore higher equity values.
What does this mean, and more importantly, is it valid?
What proponents of this argument are referring to is the Discounted Cash Flow (DCF) method.
DCF is a method of creating a model of a company’s financial standing by first forecasting its financial performance and cash flows up to some point in the future.
For example, an analyst could forecast up to 10 years worth of future cash flows to get some idea of how the company’s financial statements could look like in a decade’s time based on what is forecast.
This is the “CF” part.
After this is done, a terminal value needs to be determined.
Terminal value being a suitably dramatic name for the business’s cash flows beyond the previously forecasted time period (10 years in the above example). It assumes that a business will continue to generate cash flows at a fixed growth rate in perpetuity.
It is important to note that the terminal value makes up the bulk of the forecasted cash flows’ present value, simply because it stretches into perpetuity. This in turn makes the final equity value very sensitive to changes in interest rates.
Which is when the “D” part comes in.
In order to get an estimate of the company’s equity value today, the sum of future projected cashflows has to be discounted to the present.
As such, interest rates* matter in DCF models because of the “D” part. The lower interest rates are, the less future cash flows and the terminal value will be discounted by.
This necessarily means a higher present value, and hence a higher forecasted total equity value and share price. Which is what folks are referring to when they say that lower interest rates lead to higher equity prices.
It is important to note that this argument is based on a very broad assumption: that a lot of market participants, at least enough to heavily influence prices, are making the decision to buy stocks based on DCF models.
However, this just isn’t true, not least because of the limitations inherent in DCF modeling.
Firstly, based on our brief overview of how DCF models are constructed, it should be clear just how subjective the whole process is.
Every analyst will have different forecasts for future cash flows, growth rates, and terminal values. Hence, each DCF model will project different equity values for the same company.
Moreover, the DCF makes some big assumptions, not least of which are those used in the terminal value calculation.
How realistic is it to assume that a business’s cash flows will grow at a fixed growth rate forever?
Because of these factors, the final equity price that DCF models forecast really is good only for “reference”.
Given how quickly financial conditions, narratives, and the global economic environment can change, most market participants do not have the luxury of relying too heavily on DCF model forecasts.
That is, however, not to say that DCF models are useless. Their true value lies in the thought process that analysts have to go through while working out their forecasts.
This rigor helps them really understand the company’s business model from a micro level, but not a macro, systems wide view of interdependent variables that together affect the company’s stock price.
Ultimately, the people who buy into the low rates = high equities narrative fall into the trap of reductive thinking, attributing outcomes to a simple, single cause.
As a result, they neglect to consider the overall complexity of markets, as well as the power of human emotion and herd behavior.
*If you are interested in learning more on how interest rates affect the discounting process in DCF models, look up “Weighted Average Cost of Capital (WACC)”
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