The InterPrime Newsletter - Issue #2 The U.S. Federal Reserve

We can’t believe that it’s November already, it’s been one crazy year!

Of the unprecedented actions in the financial markets, the ones with arguably the highest impact were those of the U.S. Federal Reserve. They acted fast and decisively likely preventing the world from going into a sustained economic depression. In this issue, we will delve into those actions.

Everyone has heard of ‘the Fed’, and the mantra “Don’t fight the Fed”, but what does ‘the Fed’ actually do when they “print money” and “buy bonds”. We aim to go into the details of how they operate, what their objectives are, and detail the securities they “own”.

The U.S. Federal Reserve was created in 1913 after a series of financial crises, to serve as the nation’s central bank and bring stability to the banking system. The Fed is not “owned” by anyone.

It can be considered a de facto independent arm of the U.S. government. The Fed holds considerable financial assets and hence has earnings each year, which are required by law to be transferred to the U.S.Treasury. In 2019, the Fed remitted $54.9 Billion to the U.S. Treasury. You can check out the historical remittances here.

The primary goal of the Fed is to set monetary policy in the country; in layman’s terms this means to influence the availability and cost of money and credit to promote national economic goals.

They do this with via 3 primary tools :

Points 1 and 2 are pretty straightforward: The Board of Governors meets 8 times a year to deliberate interest rate policy, and based on their discussions and the data they see, they set the range for the Fed Funds Rate (currently 0% - 0.25%). Additionally, they continuously monitor the U.S. Banking system and determine the level of reserves U.S. banks need to hold in their Federal Reserve accounts.

Now coming to point 3 - In normal times the Fed’s open market operations are quite mundane and were described by prior Fed Chairwoman Janet Yellen as “watching paint dry”.

However, in times of crisis (i.e COVID-19, and the financial crisis of 2007-2008) they become crucial to holding the global financial system together and maintaining liquidity in the system, and thereby solvency for certain companies and institutions. We all know what happened to the storied Lehman Brothers when they ran out of “liquidity”.

We are going to highlight how the Fed has used these tools during the COVID-19 crisis and how we can possibly leverage their actions to better manage our fixed income portfolios.

Prior to COVID-19, the Fed Funds Rate was at 1.50% - 1.75%, and they had been able to reduce the size of their balance sheet to ~$3.5 Trillion.

Today the Fed Funds Rate has been set to 0% - 0.25%, and the size of their balance sheet has swelled to over $7.1 Trillion, and is projected to grow to over $7.5 Trillion in the next few months.

Source:https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm

The remaining ~$400B or so is held as a variety of loans, lending programs and swaps with corporations, domestic and foreign banks as well as other central banks. You can get all the gory details here.

As you can see the majority of the holdings are US Treasuries and Mortgage backed securities (issued by the U.S government agencies Fannie Mae, Freddie Mack & Ginnie Mae). The primary reason for this is to encourage investors to buy more “risk assets” as the Fed buying in the treasury and mortgage market keeps yields depressed.

The buying of U.S. Treasuries and Mortgage bonds was something that the Fed did during the 2007-2008 financial crisis as well. However, as part of their COVID-19 response they went one step further and started buying Investment Grade Corporate Debt & Municipal bonds as well as the ETFs that track these securities! 

This was an unprecedented move, and one that they took in order to calm these markets in the panic of COVID-19. The Fed became the buyer of last resort, and one that was willing to buy at any price, generally benefitting the sellers.

Here are the major holdings of the Feds corporate bond & commercial paper portfolio.

The Fed has said that they are going to be holding these to maturity, and their weighted average maturity is 2.9 years.

The Fed holds a wide basket of corporate bonds across all the major industry sectors. The 3 largest individual issuers represented are Verizon, Volkswagen & Toyota!

The Fed also took the unprecedented step of buying bond ETFs as part of their COVID-19 rescue efforts. These include junk bond ETFs in addition to Investment Grade ones!

For those of you that like to geek out on stuff like this you can find all the details and disclosures from the Fed here. All of this data has been sourced from the Federal Reserve here.

The Fed has slowed their purchases of corporate bonds in the last several weeks, as the markets have stabilized and are functioning as the Fed expects. However, the Fed continues to tell the markets that they stand ready to act, and support the markets in any future instability.

This gives us a lot of comfort when we buy these bonds for clients as we know that they are implicitly backed by the Fed at these prices. We are always available to talk markets, so if you would like to get into more details, please reach out!

When whaling was an accepted practice, the call of “Thar she blows” was the signal that the whale(s) unfortunately tipped their location to the hunters. The water spouts these majestic animals shoot into the air were often their demise.

In the financial world it is common to call a large trader or institution a “whale”. When they start an investment position, the dollar amount they put to work creates a ripple investors can notice.

Back in the day you would only see these massive trades by scanning or manually charting the volume of each trading day. Both for individual stocks or indices. Now thanks to computers everyone can create a “volume scan” that automatically brings trade activity splashes into view.

The theory goes that when these types of footprints appear, there could be a change in price direction. Or the “whale” may have particular information that the rest of the investment world does not have. In the purest sense, if you see them, you must investigate.

Historically, noticing a “whale” in action could prove to be fruitful. One example that comes to mind is when George Soros tried to break the Bank of England in what is known as Black Wednesday. A second was when JP Morgan “whale” Bruno Iksil was splashing in the credit default swaps market (CDX).

George Soros went down as a champion for his trade because he netted over an estimated $1 billion in profit. Mr. Iksil got blown out. The investors who took the other side of Iksil’s trade were handsomely rewarded.

Around August, footprints of another “whale” started to come to light. This time it was in the US stock option market. Notably Nasdaq technology shares.

There are two types of options. There are calls and puts. A call gives the buyer an option to BUY a stock at a specific price during a specific period. A put gives the buyer an option to SELL at a specific price. Like insurance.

The thing to remember about options (and all trades) is that there are two sides to each trade. A buyer and a seller. The situation in August revolved around buyers of calls.

When you buy a call option the person on the other side of the trade tends to be a bank or institution. When they sell you the call they receive a payment from you. They then hedge their position by buying the stock tied to the option.

You believe Apple stock is going to trade higher in price by the end of year. You either pony up the full cash amount or you buy an option for a fraction of the cost.

If you buy the options, the seller of those options will buy Apple stock to hedge their risk.

As you can imagine this could produce a positive feedback loop. If more and more people buy similar options betting on higher prices, the banks will need to buy more and more stock to hedge. A self fulfilling prophecy!

This is what appears to have happened in August- Softbank was splashing roughly $30 billion to options of US tech heavyweights (source: Financial Times). This caught the attention of retail investors who also started to buy options. This forced the banks to buy stocks outright. Up, up and away they went.

The August “melt up” stopped at a new all-time high as the calendar flipped to September. The markets then had a violent week of a sell-off and have not gained ground since then.

Whales are not only active in stocks or options. The previous section of this issue highlights the largest whale of them all — The Fed, who is currently active in the bond market.

Our hope with highlighting both the Fed activity and these “whale” anecdotes is to show you one way to look at what moves the markets. You can sum it up in a paraphrased line from the great investor Stanley Druckenmiller:

(Excerpt from Stanley Druckenmiller speech at the One Tree Club in Florida, 2015)

Mike did a webinar with ShayCPA, a SIPS supporter on “Managing your cash as a Startup”. They covered best practices on keeping cash safe, liquid and earning a reasonable rate of return. You can check it out here.

Steve Schepman, prior CFO of First Bank ($12.5B+ in assets) was kind enough to do a guest blog post on the best practices of managing corporate finances. Thank you Steve!

For those of you who are interested or have used Prime Money Market funds to generate some additional yield on your capital, we wrote up a detailed analysis of them here.

As always, please do not hesitate to reach out with any questions, comments or feedback!