Friday, December 9, 2022

What is the US Fed, and why are stock markets affected by its policies?

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Here’s what the Federal Reserve System, the country’s central banking system, does:

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In summary, since the United States dollar is the world’s reserve currency, the Federal Reserve essentially has the levers to manage liquidity (the supply and flow of money) in the United States and across the globe.

Before I go any further, it’s vital to realize that there are three basic asset classes that fight for money in the universe of financial assets: debt, equity, and real estate.

  • Money (cash)
  • Credit (bonds)
  • Equity (stocks)

You may have heard of the phrase quantitative easing (QE), which refers to a kind of monetary policy in which central banks from all over the globe may participate (also called money printing). Here is a decent flow chart to take into consideration…

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As you can see, the Federal Reserve has direct influence over the bond market, which implies that they also have indirect power over the two other asset classes, cash and stocks, as well.

As a result of the Fed’s creation and lending of money to itself by purchasing bonds, bond yields decline, making bonds a less attractive investment compared to stocks (as well as cash, since when the Fed “prints,” the value of the dollar likewise decreases in purchasing power).

A natural consequence of the Federal Reserve’s money production is that capital will flow into the stock market as a result of the constant competition for capital among bonds, cash, and stocks.

When the Federal Reserve creates money in this manner, interest rates are cut, which encourages people to spend more money (which is good for the stock market). But, more crucially, if banks do not have enough bonds to buy, the Fed will purchase bonds from non-bank businesses such as hedge funds, insurance firms, and other such organizations, who will then use the money they get from the Fed to invest in the stock market.

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This is a useful graphic to keep in mind…

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When the economy is expanding too slowly or is stagnant, the Federal Reserve will intervene to infuse liquidity and decrease interest rates to stimulate growth. In the reverse situation, when the economy is expanding too rapidly and inflation is running too high, the Fed will attempt to limit liquidity and increase interest rates by raising rates. It’s all a cycle, really.

Having said that, I believe the Fed is either deaf or blind…

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Or they aren’t particularly excellent at what they do…

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Alternatively, they may have ulterior intentions (which is the most probable situation)…

Consider the following scenario: the members of the Federal Open Market Committee have money invested in the stock market, which implies they have a vested interest in the stock market rising in value.

Would it really surprise anybody if they just continued to create more money in order to drive the stock market higher and higher indefinitely?

Take a look at the amount of debt that the Federal Reserve has amassed over the years….

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Debt is OK as long as we are able to pay it back; but, what happens if the quantity of debt we have exceeds the amount of money we earn each year?

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All of this invites the question…

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And, based on their previous actions, it is quite probable that the Federal Reserve will continue to manufacture money and inflate the value of their debt away.

Due to the fact that the Fed’s money printing is correlated to how the stock market performs, rather than a theory or hypothesis, this will essentially make those who do not have money invested in the stock market much poorer, and those who do have money invested in the stock market much richer. This is a fact, not a theory or hypothesis.

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If you still don’t trust me, consider the following:

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This is why you should not only be investing in the stock market, but you should also be investing in assets that will gain from the Fed’s machinations.

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