Thursday, February 3, 2011

How The Fed Raises Stock Prices: Part 1

I would like to talk a little bit about what is taking place both in the bond market and the stock market, then show how it ties into the Federal Reserve's activities.  I want to try and provide a simple example to show how money is flooding into both markets through the use of what the Fed terms the "Permanent Open Market Operation" (POMO).

Because our government is bankrupt, they need to borrow money from the market in order to pay their bills and postpone the coming formal bankruptcy or default.  They do this by holding auctions every month where investors bid on how much they will pay for an I.O.U. from the government.  The government promises to pay back the I.O.U. in full plus interest every month for a set number of years.  These are called treasury bonds.

The investors that come to the auctions are called Primary Dealers, which are composed of the largest investment banks such as Goldman Sacs and JP Morgan.

Let's talk about how this process works with a simple example:

Goldman Sacs shows up to a treasury bond auction on Wednesday and purchases $10 billion in government treasury debt (bonds). 

The government now has $10 billion in fresh cash available to pay  $150,000 in salary and benefits to a federal worker who is probably about $120,000 a year overpaid.  This money is then spent by that federal worker into the economy providing a stimulating boost to restaurants, clothing stores, and car dealerships.

For years this process has been paid for by the Chinese, but it essentially came to an end 2 years ago when they stopped purchasing our debt.  (Their total treasury accumulations are about where they were during 2008.)

To fill the void, the Federal Reserve has stepped in with a printing press. (I'll get to how in a second)

This allows our government to overpay their workers and never cut entitlement spending such as social security, medicare, food stamps (14% of population), and unemployment benefits. (17% of population)

It allows the government to provide or guarantee 100% of the new mortgage loans for every American in the country. It allows our military to be large enough to not only protect our home country (which is what a military designed for), but to be large enough to guard every city, town, and hut around the world while simultaneously fighting endless wars.  We will most likely soon begin military expansion onto other planets.

This process creates a "miracle" economy where you enjoy can the never ending benefits of the spending today and you have to pay....never.

In addition to this wonderful boost to our sagging economy the Federal Reserve has figured out how to boost the other feel good elixir: The Stock Market.

Here's how:

When Goldman Sacs purchases the $10 billion in treasury debt at the auction the government holds, they then go back to their office and begin collecting interest on the I.O.U.'s.

The Federal Reserve then shows up to Goldman Sac's office in nice black SUV's to conduct their "Permant Open Market Operation."  They hand Goldman Sacs $10 billion in freshly printed dollars and they take the I.O.U.'s that Goldman Sacs just purchased.

Here's where it gets fun.  Goldman Sacs now has $10 billion in cold cash to go out and have fun with.  So what do they do?  They go shopping at the stock market.  They go buy oil futures.  And they go buy some something very, very fun right now: agriculture.  Also known as food.

As they bid up the prices of these goods with the fresh, printed, free money, it causes prices of all assets to rocket higher around the world.  This is how inflation is created. 

This hopefully explains in easy to understand terms how the overall magic trick is performed.  Next up I will explain some of the numbers behind the operation and the effect on stocks, commodities, and bonds.

Coming Soon:  How The Fed Raises Stock Prices: Part 2

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