On June 25, the Federal Reserve quietly issued an order to the 30 largest banks in the US, banning them from engaging in stock buybacks and limiting the number of dividends they can pay.
It didn’t get all that much media coverage because it’s a technical rule. However, it also has some political implications.
And what no one has talked about is the Forex implications.
This is a good opportunity to illustrate the connection between the stock market and forex. It’s also a good way to point out why it’s advisable for traders to keep an eye on equities, even if they are only trading currencies.
The Populism and the Technicals
Like many technical financial issues, this order from the Fed got some erroneous coverage in some of the more popular media.
There has been growing discontent among the population over stock buybacks. Many political activists have deemed them simply a means to inflate stock prices.
Therefore, there have been increasing calls to limit or ban stock buybacks as a practice.
The Fed’s technical order seemed to play into that movement. However, the Fed’s move has little to do with inflated stock prices. They’d just finished running stress tests on the banks, calculating the worst-case scenarios they saw that might affect the banks from coronavirus.
The rule has to do with ensuring bank solvency, by ordering banks to not deplete their own cash reserves during the pandemic.
Once the Fed deems credit risks are over, the rule will be rescinded, and banks will be able to “backpay” their shareholders.
What Are the Effects on the Stock Market?
Practically speaking, little to nothing.
Most banks had already suspended their buybacks and dividend payments, as had virtually all companies impacted by coronavirus. The whole financial crisis aspect was driven by companies desperately trying to preserve capital, and banks were no exception.
All the rule does is officially mandate something banks would have done anyway.
Stock buybacks are a way for companies to return capital that was invested through share issues. By buying and canceling the shares, the company’s value is concentrated in the smaller number of remaining shares, thus increasing their value.
The practical result for traders is that the stock increases the price. And, if enough companies do it, then the stock market increases in value.
What Are the Effects on Forex?
Indices have a reverse correlation with forex.
Typically investors hedge their assets between bonds and stocks. If the stock market goes down, it means people are pulling money from stocks and investing in bonds.
More demand for bonds increases bond prices, making them more attractive. Higher bonds imply the currency is worth more, so the currency gets stronger.
If businesses in the US are not doing buybacks, there is less impetus for growth in the stock market. The side effect is that the US bond market is more attractive, which in turn strengthens the dollar.
But the Fed’s rule applies to only 30 banks. This is a very small fraction of the stock market, and therefore, it’s unlikely to have a significant impact. Unless the rule gets extended to more stocks in the future, of course.
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