Why central banks mandates should include stocks?
By: Stephan Amosov
Tags: Equity, Financial Innovation, Monetary Theory, Equality, Central Banking

It helps to better shape their future exit strategy, smoothen market disbalances and tame inequality growth.

In early-2000s I have been modeling exchange trading process by use of kinetic equations. One particular outcome of these purely numerical studies was that increased market volatility inevitably results in accelerated concentration of wealth within a smaller percentage of market players. Despite this purely theoretical relationship between volatility and wealth distribution has not yet been properly confirmed by comprehensive analysis of real life data, the suggestion itself seems pretty obvious (remember, after each financial crisis we hear that rich become richer while poor become poorer).

Assuming this suggestion is fully applicable to public stock markets, it would be fair to propose new mandate for central banks. Namely, along with inflation and job market, central banks should now target public stock markets aiming at having short-term surges in their volatility tamed, perhaps via injection of liquidity and price support. I know the idea seems disputable and even counterproductive at the first glance and has multiple opponents in central banks, governments and societies. It has plenty of counter-arguments, with the strongest one being that public money should not be used for bailing out private shareholders unless the opposite may cause substantial damage to the public interests. True! However there is a strong evidence that at the current state of public markets elevated price volatility does affect public interests negatively!

Indeed, shareholder structure of public companies is nowadays dominated by institutional investors who are managing various pools of entrusted investments of ordinary people such as retirement pension plans, life insurance portfolio bonds, individual saving plans, and even sovereign wealth funds. Particularly, that is the case for constituents of major stock market indices in developed economies such as S&P 500 and the likes, where such investments take considerable part of total capitalization.

And vice versa, with 40/60 proportion for bonds and stocks considered as classic rule for investment portfolios (although some people suggest 20/80 would be more justified for low interest rates environment where we are now for another decade), it makes sense for central banks to extend their mandate to their equity part too.

Second most popular objection against government interventions is a belief that the market should resolve it on its own. The problem is that its invisible hand is now swamping in massive floods of artificial liquidity at forcibly low rates.

Tops and roots

Another important consideration here is asymmetrical risks and rewards distribution between professional market players such as brokers and investment managers, and their clients, i.e. retail investors and pools of public money such as aforementioned pension funds and sovereign wealth funds. At the end of the day, it is the client who bears all the downside risks and takes the first loss. Even rarely seen in publicly offered products success fee structure does not fully align economic interests of market professionals and their clients. In other words, it is general public en masse who is getting all the downside from increased volatility. And vice versa, all the upside goes to market professionals — just look at the recent reports of Wall Street banks as an evidence. Typically, governments encourage people to invest into public stock markets by offering tax benefits and preferential treatments such as collective protection and investment insurance mechanisms, etc. Obviously, it is being done with sensible purposes, such as stimulating private investments and individual savings of the (most populous) middle class. However It also means that to certain extent governments are essentially taking responsibility for the outcome of such encouraged investments.

The idea of central banks targeting volatility of public stock markets may well get political support. Indeed, any well-informed citizen would say that you can’t direct retirement pension savings of ordinary people into the wild jungles of modern financial markets which became a patrimony of hedge funds, UHFT traders and all kinds of insiders, without guaranteeing proper security and taking ultimate responsibility for people’s investments. Yes, markets can fall down in times of recession however encouraged investments shouldn’t systematically underperform the market average with heavy difference. Nobody would want to get caught in the market deep while entering retirement age, with all equity holdings in pension plan being mandatorily converted into low-yielding government debt for annuities.

This responsibility should naturally be “outsourced” by governments to their central banks, as the solution mostly lies in providing liquidity to the markets in critical moments. Note the liquidity here means not only the cash, but also stock liquidity, i.e. central bank is supposed to sell the stocks if and when their prices are soaring too high.

Why equities are extremely sensitive to near-zero rates?

Growing inequality caused by increased stock market volatility is not the only reason now for central banks to step in. There is another one barely less important, namely heavy inflation of asset prices (including equities) caused by massive central banks action. And it’s not only tremendous increase of their balance sheets, but also infinitesimal rates which matter even more now.

Simple DCF model tells us that with long-term rates anchored near zero for decade(s) ahead (anyone doubts?) the discount factors in valuation sum tend to one. I.e. the valuations of companies gravitate to the sum of all future profits which in theory could be infinite! In my view, this is (one of the) the main reason why stock prices of debt-free tech megacaps are soaring in post-pandemic environment. This new economy has far better chances to survive as a business in the long run in comparison with most traditional industry behemoths of today, so its discounting horizon can be well beyond next decade.

Another purely mathematical consequence of the DCF model is that stock valuations are far more sensitive to the rates at zero, rather than any positive rate. In other words, the valuation effects stemming from an increase from zero to 0.25% are far more appreciable than that of, say, from 2% to 2.50%. This sensitivity is apparently the biggest problem for central banks pondering their exit strategies, as increasing key rate from zero even by a quarter would generate earthquakes and tsunamis in equity markets. It’s better to think of it in advance. One of the ways to cope with stock price gains attributable to artificially low interest rates is to try to dilute excessive revaluations thus collecting some of silver bullets shot by central bank into credit markets and ricocheted into equity universe to replenish its armory for future battles. I will propose a receipt later on.

So, zero is a point of singularity, where stock prices are heavily distorted, and eliminating the distortion could be way too costly. Obviously, such a distortion should be carefully managed by central banks, the earlier the cheaper.

Powell Put and Golden Call

Let’s assume now central banks have set volatility of public equity markets as one of their targets. How they could handle it in practice? Obvious mechanism is a market intervention which is pretty common instrument in FX and government debt. In case of considerable (beyond trading intervals) price movements central bank could intervene and buy single stocks, index futures, or ETFs associated with equity indices. Use of public funds for support of tumbling equity markets is not something totally unusual. Recent examples are Chinese government institutions buying domestic stocks in 2014, Russian VEB in 2008, and Hong Kong in 1998. The latter has even offered some upside to the market by launching TraHK fund to dispose the acquired portfolio. This proved to be smart and elegant exit strategy to the HK government. Economic efficiency of these support measures was positive in all these cases, from both market recovery perspective and trading profits of supporters.

The FED, although repeatedly rejecting the idea of stock market intervention in its rhetoric, certainly looks at plummeting stock prices as one of indicators of whether markets need its immediate action. Clearly, the FED is already affecting stock valuations by injecting liquidity into adjacent layers of capital structure such as credit. That is a phenomenon which is widely known as Powell’ put, named after the FED chairman Jerome Powell.

However, increased volatility is caused not only by falling stock prices, but also by these growing too precipitously. With some modifications in laws and rules, central banks can be armed to combat such unhealthy price growth, too. Why is it deemed unhealthy? Simply because it is driven by lack of liquidity in stock and excess of liquidity in cash, and that is exactly the problem which central banks should be aiming to manage.

Proposed modification is fairly simple: in every IPO / listing the issuer writes a call option to central bank for, say, 10% of its free float. The strike price of the call option would be defined as actually achieved market price at execution, and execution would be triggered by too quick price growth of the issuer’s equities, (say, by more than 35% per week/month whatever is deemed appropriate for a particular equity market), and, importantly, of a broad market stock index where this stock is a constituent (by, say, 25%). The latter condition ensures that the mechanism targets systemic revaluations of the whole stock market, not a single story. Let’s name it a golden call. Just to add some intrigue and flexibility, execution could not be automatic, i.e. it could be at sole discretion of the central bank to decide if intervening or not in each particular case. If markets acknowledge the central bank could act, they may get calmer without any action.

Now, let’s assume the stock price is growing too swiftly, which in turn triggers the execution of golden call. Central bank would effectively sell in the market the stocks acquired from the company at exactly the price of sale. It could be done via bookbuilding and underwriters or in direct sale on the open market. Importantly, central bank takes no market risk here as it sells to the market exactly at the price it buys at from the company.

To close the circle of money flows, the company will be obliged to immediately place the proceeds from call execution on a long-term deposit with central bank, say for 5 years at least, at its key rate. Simultaneously, it will write a put option to the central bank for some amount of shares valued at say 75% of deposit.

If stock price drops within next five years, the central bank will buy the stocks back from the market, to immediately on-sell these to the company. Simultaneously, the deposit will be redeemed early, stocks bought by the company from central bank will be paid from early redemption of deposit, and the remaining 25% of deposit plus (or minus) accrued interest will be returned to the company thus strengthening its balance sheet. As simple as that!

The costs and the benefits

Such a mechanism has an obvious drawback of diluting existing shareholders when golden call is triggered, at the same time forcing the company to place stock sale proceeds at the lowest possible rate (maybe even negative). However, with such an appreciable cost paid, it also brings a great advantage of guaranteed decrease of volatility of the stock market on both sides. It. also acts in a right way in a sense that returned remainder of deposit is certainly enhancing the credit profile of the company and hence improving its equity valuations in falling market. It could be repeated as many times as necessary, with re-establishment after each circle, until it is enough to curb enormous price growth or its steep drop.

Effectively, by executing golden calls, the central banks will absorb excessive part of. cash liquidity they are pumping into credit markets now, thus making their future exits smoother and providing more confidence to the market. Simply because they will have enough cash to support falling stocks and make the balance sheets of public companies more robust exactly at the time when it is needed.

Limiting equity markets volatility is certainly good for investment portfolios of ordinary investors. That would effectively help to prevent increasing inequality within the core of any society — its middle class, who is an ultimate investor into the economy.