How the Fed Printer Goes BRRR

“Vaccination levels are rising. Fiscal and monetary policy are providing strong support. The economy is reopening, bringing stronger economic activity and job creation. That is the high-level perspective—let's call it the 30,000-foot view—and from that vantage point, we see improvement. But we should also take a look at what is happening at street level. Lives and livelihoods have been affected in ways that vary from person to person, family to family, and community to community. The economic downturn has not fallen evenly on all Americans, and those least able to bear the burden have been the hardest hit.” – Jerome Powell (emphasis added)

It is quintessentially Orwellian to hear one of the primary architects of the very policies that radically increase economic inequality bemoan the unevenly distributed recovery from the Covid-19 pandemic. But I digress.

This might come as a surprise to you, but there’s actually serious and thoughtful debate between deeply intelligent people about whether the open market operations of the Fed, colloquially known as quantitative easing (QE), money printing, or Fed Printer Go BRRR, actually cause stock prices to go up, thereby enabling the rich to get much richer. In this piece, I thought I’d cover the most compelling argument for that proposition I’ve heard, which was articulated on one of my favorite podcasts, The End Game, hosted by Grant Williams and Bill Fleckenstein.

Before jumping into all that, a brief primer on what the Fed has been up to in response to the Covid pandemic. The Fed has been buying $80 billion of Treasury securities and $40 billion of agency mortgage-backed securities (MBS) for a total of $120 billion each month. The Fed’s balance sheet is thus expanding at a hefty clip of $1.44trillion per year, or roughly what the entire US federal government collected in taxes in 1996. After reaching a pre-pandemic low of $3.9 trillion in late 2019, the assets held on the Fed’s balance sheet have ballooned to over $8.2 trillion today. Forget for now that the Fed actually restarted aggressive QE months before Covid was a thing – we’ll come back to that later.

When the Fed talks of tapering, what they mean is slowing down the rate of purchases gradually, eventually even allowing for the balance sheet to shrink again (gasp!). To be clear, at this point all the Fed is doing is mentioning that they might someday begin thinking about eventually talking about possibly beginning to taper.  By the time you are done with this piece I think you’ll agree with me that the Fed has passed the point of no return. They simply can’t taper, so they won’t. 

How does all this money, used to buy debt, find its way into the stock market? Is there a transmission mechanism that can be identified? For a very plausible answer, we turn to Mike Green, Chief Strategist at Simplify Asset Management. Last year, Green appeared on Episode 3 of The End Game and made heads spin (the episode is free to the public and can be found here). In a tour-de-force appearance that lasted more than 100 minutes, Green made some profound observations on a number of critically important topics, including the issue at hand. I should warn you, however, that Green is quite cerebral – and I mean that in the most complimentary way possible. I’ve listened to the episode at least three times and I still can’t say that I fully understand all of it! Not so terrible for a chicken, I figure.

Let me do my best to distill this to the simplest example possible, and then generalize it across the broader stock market structure. There’s some $10 trillion sitting in direct contribution retirement accounts in the US, much of it in 401(k) plans, and a further $12.6 trillion in IRAs. That’s a lot of chicken scratch. 401(k) plans, in particular, usually offer participating employees limited investment selections, often a mix of company stock and balanced index funds. One popular example of a 401(k) balanced fund investment option involves picking a year that you wish to retire, say 2040, and letting the fund do the rest. Such funds are structured to own a fixed percentage of stocks and bonds that is programmed to become more conservative over time (i.e., less exposure to stocks and more exposure to bonds as you get closer to retirement).

Imagine a large fund is supposed to maintain a strict 50:50 stock:bond allocation for this calendar year. When the Fed buys bonds, thereby suppressing interest rates, the market value of bonds goes up. If I own a 50:50 fund and the value of my bonds goes up, that fund is forced to sell some of my bonds and buy stocks to maintain the balance. And therein lies a critical transmission mechanism. It seems obvious in hindsight, but it takes a mind like Green’s to lay it all out so cleanly.

The Fed buys bonds. My rules-based fund sells bonds to buy stocks. Stocks go up. And repeat.

And as Green explains, this is all further amplified by the manner in which these funds buy and sell securities. As passive investors, such funds usually express their market exposure agnostic to valuation: the current price is dictated by the market and the market is always right. If more dollars come into a fund via contributions, the fund buys at the market. If dollars go out through redemptions, they sell. If they need to rebalance between stocks and bonds, they buy and sell at the current price in both markets. They aren’t price sensitive – they’re execution agnostic. As more and more of the market behaves this way, things can get extremely volatile. When everybody is on one side of the boat, the boat tends to list.

Now you can dress this up with fancy language, spread it across all manner of exotic fund strategies and market actors, and even sprinkle in a healthy dose of leverage, but at its core, the example described above seems operative. When the value of bonds goes up, entities are free to buy more stocks, and many of these entities do so passively. If you can understand how the Fed’s purchases transmit into your 2040 targeted retirement fund, you can understand how a structured fund pledging bonds as collateral to buy equities is similarly stimulated.

Of course, there are other more indirect ways that the Fed drives stock prices higher. Low interest rates reduce the discount rate for future profits, making high-growth companies more valuable. Market participants assume the Fed always has their back, which makes risk-taking, um, less risky? But Green’s direct transmission explanation was the first I’d heard that sounded irrefutable.

And the scary part comes when you ponder what happens in reverse.

As Green describes in his interview, if enough passive investors agnostically push the sell button, the market can go no bid. Like, no bid. Like, the market goes to zero. The current price is dictated by the market and the market is always right. There are scenarios where zero is right. It sounds crazy, and it almost certainly would never happen, but it could happen, and that it could happen means the Fed would have to step in once again. We are stuck in a doom loop.

Want proof? Consider what happened in late 2019, long before Covid splashed onto the scene. The Fed tried to taper, and the experiment didn’t last long. Beginning in 2018, the Fed slowly allowed their balance sheet to shrink, but then something in the market broke. The full history isn’t known, and might not ever be known, but the rumor is that several large, highly-leveraged, systematically important funds got over their skis and began to wobble. The Fed was forced to reverse course, and the printer went BRRR again.

With the Fed’s balance sheet currently twice the size it was in 2018, the stakes have only gotten higher and the options more limited. Rich people disproportionately own stocks. Policies that drive stock prices higher must come at the expense of those unable to participate in the capital markets. If said policies also lead to higher inflation (an entirely separate debate, but one worth having), that’s an unsustainable one-two punch for the less wealthy in our society.

I view societal inequality as a game of Jenga. There’s only so many bricks you can take from the bottom to put on top before the entire edifice collapses. Feels like we are getting close.

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