The Federal Reserve's policy-making Open Market Committee met last week and the stock market swooned. This extraordinary degree to which prices of stocks and bonds respond to actions by the Fed, along with the European Central Bank and the Bank of Japan, illustrate an unhealthy reliance on central banks.
Monetary policies have turned financial instruments - stocks and bonds and the markets in which they are traded - upside down. Stocks are being treated like bonds and bonds like stocks. David Rosenberg, a Wall Street economist, made that insightful observation in an op-ed in the June 11 Financial Times.
All this is due to the extraordinarily low interest rates that have prevailed for nearly five years - part of ongoing emergency actions taken by the Fed and other central banks to keep the economy from falling into another depression.
Traditionally, bonds have been the vehicle of conservative investors seeking security over returns. Stocks, with returns not guaranteed, were more for speculators seeking a greater payoff for taking on greater risk.
Now, many speculators are purchasing bonds, or more exotic financial instruments, that increase in value if bond prices drop. And a higher proportion of stocks are being bought for the value of quarterly dividends from solid companies rather than the potential for rapid price appreciation.
Interest rates have to increase at some point, and when they do, prices of bonds will drop - which the bond speculators are counting on. No one knows when this will occur. And hence the extraordinary level of interest in any possible indicators, regardless of how fanciful, along with anything Fed Chairman Ben Bernanke happens to say.
Indeed, adding to the confusion, we have stock investors selling at any hint of good news, for fear that the improving economy will force the Fed's hand in raising interest rates.
To understand all this, here are some basics:
Bonds are standardized IOUs issued by corporations or by governments ranging in size from the Edgerton school district to the U.S. Treasury. They document the terms of a loan, made by the "purchaser" of the bond, to the seller. Legally, they are little different from the promissory note that one might sign in obtaining a car, student loan or home mortgage.
The difference is that car, student or mortgage loans all are distinct from each other, in amount, maturity, interest rate or other terms. In contrast, the bonds in any one issue are essentially identical in denomination, maturity, security and other terms.
Stocks are fractional shares of ownership of a corporation. They give the owner the right to a proportional share of the profits of the business. If you own 200 shares in the ABC Corp., out of a total of 1 million that it has issued, then you have the right to 200/1,000,000ths of any dividend its directors decide to pay out of profits. And you have a voice in electing those directors.
In general, bonds are safer. They represent a contractual commitment to strictly determined principal and interest payments. For a corporate bond, these promised payments must come before any payments to stockholders. In some cases, they may incorporate a mortgage on physical assets, like locomotives or a power plant, that would legally become the property of the bondholders in case principal or interest were not paid.
For government bonds, most pledge the "full faith and credit" of the unit of government issuing them.
In practical terms this is a commitment that taxpayers will have to pony up whatever amount is necessary for bondholders to get principal and interest. (Some state and local "revenue" bonds lack this guarantee and bondholders are only guaranteed the right to revenues produced by a specific tollway or parking ramp.)
In contrast, owners of shares of stock are, in a classic phrase, "residual claimants." As the business sells its products its employees must be paid for their labor and suppliers for their raw materials. Any taxes due must be paid. Banks and bondholders must get principal and interest due. Only after all such other obligations are met do the share owners get anything.
Moreover, if the business is not profitable, then the right to a fraction of the profits will not be a particularly desirable asset. The market value of the share of stock may drop, even to nothing. There is no guarantee that anyone buying a share of stock will get her principal back.
Thus, bonds traditionally are a less risky investment than stocks.
However, stocks offer much greater potential for gain. If the company does well, dividends may be very high and the market value of the share of stock may soar. Stockholders can become rich, as has been true for those who bought Apple, Microsoft or Amazon stock early on. But they can also lose everything.
In this, note that not all stocks are the same. Stocks in well-established, low-risk businesses, such as gas and electric utilities, could, in practice, be nearly as reliable as bonds, paying quarterly dividends with the regularity of a metronome.
Inflation rather than default is greatest risk for bondholders, and this too is controlled to some measure by a central bank's interest-rate policies. Bondholders are guaranteed to get interest and full principal too, if the bonds are held to maturity, but what one can buy with those funds depends on the central bank maintaining the purchasing power of the currency.
The historical split was that most bonds were bought by risk averse individuals or by institutions such as insurance companies and pension plans.
Most "speculation," or purchasing financial instruments in the hope of a rapid increase in their value, involved stocks.
At least until the present. And Rosenberg's Financial Times piece casts useful light on how the collateral effects of the actions of the Fed and other central banks in recovery mode will haunt us for a long time.
Write Ed Lotterman at email@example.com.