Why the Fed’s delinking unemployment from the taper affects ETFs
How has the Fed incentivized the private sector to induce job creation?
The Fed has lowered rates to the lowest level in 237 years, said Richard Fisher, President of the Dallas Fed. This has enabled corporations to “become muscular financially and rebalance their balance sheets” and created an environment conducive to job creation.
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Market mechanisms induce arbitrage between stock and bond markets
According to Fisher, what quantitative easing (or QE) has achieved is that the interest rates on investment-grade debt (LQD) are lower than forward earnings on the S&P 500 Index (VOO). This has induced corporations to borrow cheaply and invest the proceeds in the stock market to finance share buybacks and increase returns to shareholders, instead of investing in capex to induce job creation. Corporates have also engineered their bottom lines to ensure EPS growth and ensure stocks keep appreciating.
Implications: Tapering and unemployment rate delinked
Besides the arbitrage mentioned above, QE has also led to record debt issuance. Corporate bond issuance in the U.S. reached $1.4 trillion in 2013 according to the Securities Industry and Financial Markets Association (SIFMA), the highest ever in a year. Investment-grade bond issuance (LQD) exceeded $1 trillion in 2013, fueled by a flurry of issuances from blue-chip companies like Microsoft (MSFT)—with $3.3 billion in senior notes in December 2013—and Thermo Fisher Scientific (TMO)—with $3.2 billion in senior notes in December 2013—seeking to take advantage of the low interest rate environment. High-yield bond (HYG) issuance reached ~$336 billion in 2013, also a new record.
This would imply that since corporates aren’t fulfilling the Fed’s mandate of job creation to the extent required and using the funds for non-investment purposes, the decision to taper asset purchases wouldn’t really impact the job market and the unemployment rate since firms have shied away from making job inducing investments anyway. Also, market reaction to a hike in the median base rate estimate is extreme—not because it affects capital formation, but because it affects future growth in the stock markets (VOO), which (spurred by arbitrage) returned over 32% in 2013, the best performance in 16 years.
To find out what Richard Fisher had to say about excess reserves in the banking system after the onset of QE, continue to Part 5 of this series.