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This guest commentary was written on 6/4/20 by Mike O'Rourke of JonesTrading

The Zombie Market - Economic growth cartoon 10.20.215

The Fed’s overzealous liquidity pumping in response to COVID-19 and promise of perpetual support has inflated an equity bubble.

It has been reported numerous times that absent the distraction of sports the zero commission stock market has become the new venue for out of work millennials looking to make wagers. 

Today’s action was an especially ridiculous episode. A company that had an $8 million market capitalization a month ago, and did 5.9 million in revenues in 2019, had a $1 billion market cap this morning.  Furthermore, the company performed 4 stock offerings in the past month doubling its float and share count.

The craziness did not end there.  A US listed Chinese company that has admitted accounting fraud rallied as much 88%  today. 

Finally, the shares of a bankrupt Car Rental company surged over 100% on “renewed travel demand.” The behavior is absurd, and the moves are so extreme that they are dangerous to fade in a market with a broken pricing mechanism.  At this rate, China’s takeover of Hong Kong may result in a better functioning market pricing mechanism in the Far East than in New York. For the several years we have warned about policy driven broken market pricing mechanism. 

Today, the glaring disconnect between the stock prices and the devastated fundamentals intended to drive values is apparent to all. The distortions and disruptions are so extreme we are even hearing Federal Reserve confidants and former high level Federal Reserve officials publicly acknowledge the distortions. 

Earlier this week we highlighted Mohammed ElErian’s observation that the “Fed Put” was the primary catalyst in the market and that there is a risk to the pricing signals in the economy.  Yesterday, Peter Fisher made similar comments.   Fisher spent a good portion of the last two decades as the head of Blackrock’s Fixed  Income Business. 

He had also served as Treasury Undersecretary and is a former head of the NY Fed’s Markets Desk. When asked about the Fed’s approach, Fisher responded: 

“The other way the Fed is effecting this, is by intervening in the investment grade and high yield markets. I don’t think that is going to look, from history when we look back in 5 or 10 years to be the smartest thing the Fed has ever did.I think they fixing prices of those markets and that means the information content we normally attribute to those markets is less than we think it is….when you take a measure and you turn it into a target, it loses its information content."

Fisher elaborated noting that the Fed’s actions in the fixed income market do influence equities. He continued: 

“What the Fed has done to investment grade and high yield credit, they have taken the information content out and also they have made equities more volatile.  That is if the capital, think of the capital structure of the whole country, the Fed is saying I am providing a floor for the credit side of the capital structure, that means the equity slice is going to be more volatile.  And if people think happy days are here again, the Fed’s growing its balance sheet, yeah it does feel like the Fed is pushing up asset values.” 

Bloomberg television performed another noteworthy interview yesterday that ties into this discussion. The New York Fed President is also the FOMC Vice Chair. That generally makes that individual one of the three most influential Fed officials, along with the Chairman and the Vice Chair.   

Bill Dudley led the NY Fed for 8 ½ years throughout most of the recovery from the Global Financial Crisis.  During his tenure the Federal Reserve’s balance sheet grew 124% from $1.93 Trillion to $4.3 Trillion.  Note, the Fed’s Balance Sheet was $4.1 Trillion at the start of this year. Not only is Dudley no stranger to the Fed’s printing press, he was largely responsible for turning it on during both the Bernanke and Yellen tenures.

Dudley was asked about the risk of the Fed doing too much. Dudley responded:

“I think the Fed’s focus has been on basically making sure financial markets work well so people can have access to the markets.  That’s really the reason for the interventions.  Even their intervention into the high yield debt market, it not so much to bail out individual borrowers, but to make sure people can actually access that market and make sure that people can access that market and raise high yield debt.  I think they have been quite successful in those efforts. But you raise an important point, people who have high yield debt outstanding, a lot of time that has happened by choice and so for the Federal Reserve to intervene and support those asset prices, is basically creating a little bit of moral hazard, in the sense that you are encouraging people to take on more debt.”

We ourselves have said the measure of success for the Fed’s facilities will be how little they are used.  Thus far the Fed has been very successful,  2020 is likely going to be a record year for capital raising among publicly traded companies. Most of which has occurred during the pandemic.

The obvious caveat is although the facilities are not being meaningfully used yet, the balances sheet expansion has been historic.

When the Fed announced its first major policy response in mid March Chairman Powell noted that “several important financial markets, including the market for U.S. Treasury securities, have at times shown signs of stress and impaired liquidity.” 

It was reported that weekend that several hedge funds had losses in the treasury market.  The night Powell made that statement we noted: “In short, five days removed from record all time low yields and high prices, the Fed was essentially supporting the treasury market as a hedge fund was likely reducing positions.  Needless to say, if that theory is correct, hedge fund investors sold at better prices than deserved and the American public paid higher prices than they should have.” 

In his interview yesterday, Dudley stated: 

“We had a number of players the last few months that have essentially been bailed out by the Fed, people who, hedge funds that were invested in cash treasuries and short treasury futures.The Fed, basically, their treasury purchases were helping those entities unwind what was turning out to be a bad trade. When people become very leveraged and they are big enough to be systemic, then I think there needs to be some regulation to reel that in.”

While the Fed has been free flowing with its liquidity, it has not done anything to reign in excessive risk taking, instead it has bolstered it.

Dudley concluded by noting “It is one thing if you have a financial crisis every fifty or one hundred years, if you start to have a financial crisis every ten years, then the Fed’s actions are going to encourage people to take more risk in the future.” 

One of the most important factors about these comments we are highlighting is that these are made by individuals who are supportive of the Federal Reserve. They are generally not critics, but they do speak the truth as they see it. 

If Chairman Powell does not set expectations and boundaries, the reckless risk taking is a financial stability threat that will amplify the damage to the economy.   


This is a Hedgeye Guest Contributor piece written by Mike O'Rourke, Chief Market Strategist of JonesTrading, where he advises institutional investors on market developments. He publishes "The Closing Print" on a daily basis in which his primary focus is identifying short term catalysts that drive daily trading activity while addressing how they fit into the “big picture.” This piece does not necessarily reflect the opinion of Hedgeye.