The Real Reason Central Banks are Buying Stocks

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Are we wrong or is everyone else wrong?

Can we see things no one else can see?

Maybe.

We’ll start believing we have unworldly powers if this carries on.

Perhaps your editor is the ‘chosen one’ of financial forecasting.

OK. We don’t really believe that. We don’t really have special powers. It’s just that the rest of the market appears to have gone completely bonkers.

Despite all the clues, they just can’t see what’s really going on with this market. We don’t know why. It’s simple…

We’re not kidding. This market has taken by surprise some of the smartest minds in the financial markets.

Take this report from the Financial Times:

Like many investors, Mr Hasenstab [portfolio manager at Franklin Templeton] was wrongfooted by this year’s unexpected fall in US Treasury yields; also like many others, he has yet to find a single convincing explanation.

Is it really that hard?

What more convincing do these folks need other than the fact that central banks are using every power they have to keep interest rates low.

And by every power, we mean it.

How can this surprise anyone?

Governments and central banks simply can’t afford for interest rates to rise too high. The higher interest rates go, the more interest governments have to pay on new debt.

In the past, governments would have to grin and bear these interest rate fluctuations. As odd as it may seem now, the threat of higher interest rates forced governments to be cautious about going into too much debt.

We know that seems crazy. Because at the time government debt levels seemed high. Of course, that’s nothing compared to where they are now. Even the Aussie government is now in hock for $320 billion. Just six years ago the federal debt level was around $60 billion.

The five-fold increase in debt levels by the Aussie government is among the biggest debt increases in the Western world.

So with all this in mind, how can it surprise anyone that central banks and governments would do all they can to keep interest rates as low as possible?

As the chart shows, the US 10-year bond yield is already well above where it was from 2011 to 2013 during the height of the US money printing program:


Source: Bloomberg
Click to enlarge

Our bet is the US Federal Reserve won’t want interest rates going too much higher, as each tenth of a percentage point rise adds US$62 billion to the US government’s interest bill.

So even though all the talk is about the end of money printing, don’t let that fool you. The experiment in low interest rates isn’t over by a long shot. And now it’s taking a new turn.

‘Buying’ the entire Australian stock market

Another report in the FT reveals the extent to which central banks are going to keep interest rates low:

Central banks around the world, including China’s, have shifted decisively into investing in equities as low interest rates have hit their revenues, according to a global study of 400 public sector institutions.

The report suggests that central banks have increased stock holdings by US$1 trillion in recent years. That’s the rough equivalent of buying nearly every stock listed on the ASX.

It’s a big number.

But we dare say the report misses the mark. The inference is that central banks are buying stocks because they aren’t making enough money by holding bonds.

While that may be partially true, it’s not the real motive for central banks to buy stocks. In the world of big institutional investing, it’s important to understand the relative yields between different investments.

In investing, everything is about risk. Typically, big investors will compare the yield of a so-called ‘risk free’ government bond with that of the yield on a stock. If the difference between the bond yield and the stock yield isn’t big enough to warrant the risk, then investors may choose bonds over stocks.

If the spread between the stock yield and the bond yield is unusually large, then it may suggest stocks are cheap, and therefore the investors will buy stocks.

Can you see where we’re going with this?

It’s all about the relative yield

The simple fact is that if the central banks want to exert as much control as possible over bond yields they can’t just buy government bonds. They have to buy other assets too.

That’s why they bought mortgage-backed securities — to bring those yields down and make them less attractive investments compared to government bonds.

We dare say the central banks are directly or indirectly involved in buying ‘junk’ corporate bonds too — to bring those rates down so they are nearly on par with government bond rates.

The same goes for stocks. If the central banks can manipulate stock prices higher, and therefore manipulate dividend yields lower, it also reduces the spread between bond yields and dividend yields.

The narrow spread between the two makes the ‘risk free’ government bond a far more attractive investment for big investors compared to the riskier stocks.

Of course, what happens when investors sell stocks to buy bonds? Doesn’t that push stock prices down? Yes, it does, until stocks fall by enough to make the slightly higher yield more attractive, and then the stock price rises again.

In effect, the goal of the central banks isn’t necessarily to become big stock owners. Rather, it’s to manipulate the market and create a ‘new normal’ level for interest rates and dividend yields.

So far their plan appears to be working. Like it or not, agree with it or not, stocks have had a good run as this policy has played out. It will end in a bad way at some point. But not yet.

We see no reason why it won’t continue for years to come. And that’s why it makes sense to buy stocks during a short term dip.

It amazes us that so few others can see what’s really happening in the markets.

Cheers,
Kris+

About Money Morning Editorial

Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the…

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