The Investment Scientist

Fed Buying Corporate Bonds, What That Mean?

Posted on: June 19, 2020

Investor-Optimism-Fueling-Corporate-Bond-GainsThree days ago, the Fed announced that they will go directly to the corporate bond market to purchase $250 billion worth of investment-grade corporate bonds. A few of my newsletter readers asked me to comment on this, so here I am.

Basically, the Fed buying $250 billion of any securities can be seen as the Fed creating $250 billion of new money and injecting it into the economy. It really doesn’t matter whether these securities are treasury bonds, munis or corporate bonds. Munis are bonds issued by states.

So how does the Fed create new money?
The classical monetary theory posits that paper money must be backed by something valuable. Since 1974, the US dollar has no longer been backed by gold. For a long time (until 2008) it was backed by US treasuries. The Fed has a balance sheet. Let’s say by 2008, the economy needed $3 trillion to function. The Fed would create $3 trillion out of thin air and use the money to buy $3 trillion worth of treasuries. The Fed balance sheet would look like this : on the assets side, it shows $3 trillion of US treasuries, on the liabilities side, $3 trillion issued. Now the money is no longer considered to be out of thin air, since it is backed by treasuries that carry the explicit guarantee of the US federal government.

Assets —————– | Liabilities
$3T of US treasuries -| 3T of $$$

Up until 2008, the Fed did not have the authorization from Congress to buy any securities other than treasuries. But the financial crisis changed that. Partly to create money that was much needed, partly to rescue the mortgage-backed securities (MBS) market that was collapsing, Congress authorized the Fed to go beyond treasuries. During the financial crisis and its aftermath, the Fed created another $1 trillion to buy MBS, thereby injecting $1 trillion into the economy.

Assets ——————| Liabilities
$3T of US treasuries -| 3T of $$$
$1T of MBS ————| 1T of $$$

Mortgage-backed securities do not carry the full faith and credit of the US, but they do have an implicit guarantee from the US federal government. Still, after the 2008 financial crisis, the credit quality of central bank assets went down a little.

In the last three months since the coronavirus pandemic hit, the Fed has created another $3 trillion and used the money to buy not just treasuries and MBS, but also munis and corporate bonds. So now the balance sheet looks like this

Assets ———————————–| Liabilities
$3T of US treasuries ——————| 3T of $$$
$1T of MBS —————————–| 1T of $$$
$3T of munis and corporate bonds -| 3T of $$$

So, this is how money is created. The news that the Fed is buying $250 billion worth of corporate bonds, first and foremost is that the Fed is creating $250 billion worth of new money. Now I have a few questions for you: What do you think of the credit quality of the Fed’s assets now? Do they have the full faith and credit of the US? Do you think the Fed will go to the stock market directly and buy stocks?

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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