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  • Writer's pictureIshfaaq Peerally

Fed Buying Corporate Bond ETFs. What's Next for Stocks?

Since last week, the Fed has been buying corporate bond ETFs. We have been warned that there is a corporate bond bubble, a passive investing/ETF bubble. Is the Fed trying to explode two bubbles at the same time? and what does all of this means for the stock market?

So far the Fed has been buying only treasury bonds and Mortgage-backed securities since the 2008-2009 financial crisis. This was done to provide liquidity to the system and also to help those banks which had mortgage-backed securities on their balance sheet. But now, the Fed cannot buy more treasury bonds since the yield is going negative and the Fed doesn't want that. Negative yields will be bad for the banks. We can already see the poor performance of European and Japanese banks.

The second reason why the Fed is buying corporate bonds is to help those companies in trouble. If they know that there is a buyer, companies can issue more debts to raise capital. Of course, this will make them more leveraged but the Fed doesn't seem to care. The Fed is buying these bonds through ETFs (BlackRock is doing the actual buying) to remain neutral.

The third reason why the Fed is buying corporate bonds is to provide liquidity in the market. Investors can sell bonds that they don't want anymore and buy stocks or real estate.

What is the problem that the Fed is buying those corporate bond ETFs? Is the Fed really providing liquidity to the corporate bond market? When the Fed is buying these ETFs, the ETF holding companies such as BlackRock and Vanguard has to buy the underlying assets. The underlying assets are not as liquid as the ETFs themselves and the ETF may start buying lower quality bonds to keep itself liquid. Since the Fed is also buying Junk bond ETFs, the ETF start buying CCC for example if there is a lack of liquidity in BB.

Another problem will arise when the Fed stops buying. Now, there is a recession and they are buying. When they stop everything crashes. So, the Fed has to keep buying these bonds. We can already see the dependency of the Japanese Markets and economy on the Bank of Japan. Same thing with the Eurozone central Bank. We can already see a correlation between the S&P 500 and the size of the Fed Balance sheet.

With the Fed buying corporate bonds, the yield on those bonds will go down and investors will seek higher returns, in stocks. Companies can take more debts means, even higher stock prices. Stock prices can only rise as long as the Fed is buying. There will be of course, higher inflation.

What really move stock prices are growth of companies, and companies grow from innovation. Artificial growth cannot be sustained for long. We can already see Japan losing its competitiveness and innovation. As an investor, you should not focus on what the Fed is doing or not doing. You need to look for innovation. As long as you invest in innovation at the right price, you will do good.

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