Alan Cring Productions in association with Emergent Light Studio presents the Illinois
State Collegiate Compendium, Academic Lecture in Business and Economics.
This is Business Finance, FIL 240 for autumn semester 2023.
Okay special topics continued.
I will go through this, what I didn't do on Thursday, or rather on Monday and then we
will have a surprise quiz for the remainder of the time together and then you're done
for the day.
And then next week on Monday again, that's a Zoom session, first day of review and the
first day I'll lay out for you on the Zoom session, the structure of the final.
And then I'll go through some of the details.
I'll focus more on Monday on definitions, concepts and go through a few of some of those
terms if you want to ask me can you give me a definition of this or that, I can do that
as long as you don't go like 10 or more definitions but that will be Monday, a Zoom session, the
link will be in your canvas for that session.
So and it will start at regular class time and go as long as you have questions.
Real quick here, quick just a brief look at the numbers.
It wasn't a spectacular day at all.
As you can see it was an utterly uninspiring day.
The Dow oddly enough was up 0.04% and then the S&P 500 was down 0.09% and the NASDAQ
was down a little more at 0.16%.
Nothing really, that's trivial.
That's basically a flat day.
But you'll see that that was actually kind of globally what was going on.
An important part of that is that we now have the data as of today that inflation has been
brought under control.
It is coming down.
It is going to not be the job of the Fed to raise the discount rate anymore.
No longer slowing, trying to slow down the economy by draining liquidity.
Well you would think that would make the markets happy.
Yay, interest rates going down.
Well why didn't the markets react that way?
It's because they already knew that this was what was going to happen.
The expectation had already been impounded in securities prices a few days previously.
So there was no new expectations formed today.
So there wasn't really any reason for the markets to move very much today.
Just a quiet day.
Now crude oil is still in its trading band 72 to 79.
It did come up.
It had kind of a wild day.
It went up and then down and then up.
And fortunately it leveled off there at the end of the day.
So it's still in that 72 to 79 trading band.
But it seems to be kind of volatile right now.
With lots of rumors flying around as always is the case.
The traders are reacting to the best guesses they have of what's about to come about.
But there's not really any thought that there's going to be any supply disruptions from the
Middle East or from Eastern Europe.
But still the rumors are there.
Now over here the odd thing was gold was roaring its way.
It had completely broken through that $2,000 per ounce resistance level.
And it was on its way up.
And then there at the last it began to drop hard as you can see.
And it seems in the aftermarket it's still pulling downward.
So the gold bugs were excited because they thought there was some reason to see the end
of the world coming.
So they were buying their gold.
But something cooled them off there by the end of the day today.
So that's good news.
They'll be quiet we hope.
Now the 10-year bond dropped.
The yield is going down.
It went down.
Let's see if I can read that, about six and a half basis points.
Interest rates, the discount rates going down.
Interest rates in general are going to go down.
It's not going to be a spectacular drop.
The interest rates that we had there for four or five years, they are no longer going to
happen.
Not for a long, long time.
However, at least they're easing up from where they were even a few months ago.
Home mortgage rates are sliding.
They're still ridiculously high compared to what they were a few years ago.
And you're even seeing auto loans, the interest rate coming down.
But still, I got an ad from one of the major auto companies about a month ago.
7.99% financing.
Wow, isn't that incredible?
Geez, that's an awful interest rate.
Well I just got an ad yesterday.
New interest rates now for six-year loans are 10.49%.
Yes, that's a drop.
But that's still a very high interest rate for an auto loan, historically speaking.
So we are getting the interest rates down.
That's going to keep the economy on the expansion path.
We're moving from a recovery toward an expansion.
More good news was that the numbers are coming in on Black Friday and sales were record.
It was record sales.
So clearly consumer confidence is high enough that people are opening their wallets to buy
for the Christmas season for gifts.
And that's always good news.
Consumer confidence goes up, buying goes up, more jobs, more production, the whole nine
yards.
Great news.
Okay, now oddly enough, the euro and the pound both just wobbled.
It looks like it was down a little bit, but not much.
Well if our interest rates are going down, that should weaken the dollar and that should
cause other currencies to appreciate against the dollar.
So why isn't that happening here?
Most likely it's just because their interest rates are easing up too, and so it's kind
of a wash right now.
The euro was pretty much flat, a little depreciation the dollar had.
The pound just barely a little bit.
And the Japanese yen was about flat.
So there you are.
And if you look over here, the Nikkei finished down a lousy little bit, about a quarter of
a percent.
No spectacular movements in there.
And the London was down a little more.
And if you look, that's kind of the story over here.
So in other words, the world's economies, or at least the financial markets, are in
a wait and see attitude right now.
It's sort of sitting back.
If you look at volume on the Standard & Poor's 500, it's still pretty lousy against its 52
week average.
3.4 billion shares today against 3.7 on an average day over the past year.
So there is still a lot of weakness in buying activity, especially by the big dogs.
So there you are.
There's where we're sitting.
And you can look around at some of the markets, show you one right now.
I pulled up Bristol Myers here, just to show where we could be over the next year or so.
Now Bristol Myers, as you can see, it's a very safe company, beta.37, low risk investment.
PE ratio at 12.37 indicates that it is undervalued, possibly.
It is a profitable company with $3.94 per share, and it pays a little bit of a dividend.
So just to keep you in the mood of doing these, we'll look at the one year holding period
return on this company.
And we would have in one year projected $57.70 against the purchase price one year earlier
today of about $48.72 and minus one, and then you take the result times 100.
Your cap, well, let's try that one more time.
$57.70 divided by the current price one year earlier, $48.72 minus one.
So the capital gain yield is 18%.
Now if you add in the dividend yield, 4.66%, look at that.
I got to multiply that by 100 first, and then add the 4.66.
A total holding period, one year holding period return of 23.09%, and this is on a really
low beta stock.
So this gives you an indication that, doing some more research obviously, but it looks
like this is a definite buy, a good stock to have in a well diversified portfolio.
With a beta that low and returning 23.09% annual, you can't beat that.
Bristol Myers is one of those old stable companies that sells basic products and all that.
So even if the economy went to hell, it's not going to go down that much, but it looks
like that's a heck of a winner at that low risk level, and it's undervalued right now,
so this would be a good time to buy.
So as I've always said, of course, don't trust anything I tell you as far as investments
go, because I wouldn't be giving investment advice if I were good at this.
If I were good at this, I wouldn't be here.
Anyway, enough of that.
Let me tell you, I'm going to finish up, I'm not going to do the second topic, I'm just
going to finish up the Federal Reserve today, make sure you've got all that down.
Now be sure, at least listen to watch that video, I gave you the link to that video on,
it's called In Plain English, it's about the operations of the Federal Reserve.
That goes through the whole thing pretty well, but just to remind you, I had one tale that
I hadn't shown you.
This was, remember, the tools of monetary policy.
Well first of all, duties of the Fed, just to get a running start, duties of the Fed,
well the first duty was that it regulates and supervises the banks, the governors regulate,
and the district banks supervise the banks.
Two, the Fed serves as a bank for banks.
And the third one was the one where I cut off near the end, conducts monetary policy.
This is the big one.
Now I gave you the three different tools, the least used would be the required reserve
ratio, sometimes called the fractional reserve ratio.
And this I gave you last time, like I said, I'm just getting a running start.
The second tool to conduct monetary policy would be the discount rate.
Now that's a rate at which the Fed would lend money to banks.
If your bank needs $10 million, the Fed will lend it to you, and it will charge you this
rate that it sets.
This discount rate is set by the Fed.
It also serves as a signal that, well, okay, the Federal Reserve raised the discount rate
by 25 basis points,.25%.
Well that would mean that the Fed is saying that it wants the economy to slow down, so
it wants interest rates to go up.
Or the Fed lowered the discount rate.
That would mean that the Fed thinks the economy is going a little too slowly, so it wants
to juice the economy a little bit.
It wants lower interest rates.
Now what's the expectation now?
The Fed had been, every meeting it was raising the discount rate up, up, up, signaling slow
down economy, we've got to kill inflation.
But now we are pretty much assured that the Fed may actually be completely finished with
those incremental increases in the discount rate.
That's good news.
That's great news.
Happy news.
Okay.
Good news.
Now however, banks don't have to go to the discount window at the Fed.
They can borrow from each other in the federal funds market and they will pay the federal
funds rate.
This is not set by the Fed.
It's set by the supply of money and demand for money in this vast pool of bank funds.
So it is set by market forces.
However the Fed will give a target what it wants it to be.
And the Fed has this last tool that I'm going to tell you about that it uses to push that
federal funds rate to where they want it.
Now again, just to emphasize this, the federal funds market is this vast pool of the money
of banks.
That's kind of oversimplifying it, but it does it pretty well.
So there's this ginormous pool of trillions of dollars.
This is the federal funds market.
And it's just all this money that's swirling in the banking system.
Now it might sound kind of paradoxical.
It's very real, but it's kind of diffused.
It's sort of like air.
Well we know it's there, but it's here, here, it's everywhere.
And for the Fed to add money to it or drain money from it, it's sort of like breathe,
blow it over here.
That's kind of what the Fed does with this last operation that it does.
It's called open market operations.
OMOs.
Now I'm going to juice your thinking a little bit here just for a minute.
Either or not, you're going to be the leaders of the free world someday, pretty much every
one of you.
You're going to know things that hardly anyone else knows.
Some people just don't want to know this.
Some people can't understand it.
But that's where we come in.
We know about this.
These open market operations are to the tune of hundreds of billions of dollars every day
swirling back and forth through the economy, through the banks, even through our own bank
accounts.
And hardly anyone knows this is happening.
And it is the force that is maintaining control of the economy in the short run.
So you're going to know about something, even to try to explain it.
You might get someone to kind of get how they work, but would they know how incredibly forceful
this is?
Probably not.
So that's where we come in.
We have to know this.
We have to understand it because we are the ones who will be trying to know what it's
going to do to our companies, know what it's going to do to the economy, and all that kind
of stuff.
Okay.
Now, I'm going to go away from the federal funds market here for a minute.
And I want to give you one last part about the Federal Reserve.
Now the Federal Reserve, remember, there are seven governors and 12 district bank presidents.
One of those districts is kind of more important than the other ones.
It's the Empire Bank, the Federal District Bank of New York.
It has kind of a pivotal role in the machinery that I'm going to show you here.
But the Federal Reserve has a special committee.
It's called the Federal Open Market Committee, the FOMC.
In fact, that little cheesy animated video talks quite a bit about this.
And they do a really good job, maybe even better than I do, because it's kind of a
summary, but they got it.
Okay.
Now, the Federal Open Market Committee, all seven governors are on this committee plus
five district bank presidents.
Four of those district bank presidents serve rotating two-year terms.
Okay.
So in other words, you're the president of the District Bank of Atlanta, and you've just
done your two years.
So I'm the president of the District Bank of Cleveland.
I might be the one.
You're done with your term, and then I step in, and it's my turn to be on the FOMC.
And that rolls around.
Now there's one permanent member.
That's the Empire Bank president.
And there's a reason.
That one is...
There's a reason.
That's the New York Fed District Bank.
That president is always going to be on the Federal Open Market Committee.
He or she is going to be a fixed thing like the seven governors are.
Now, this FOMC meets formally and officially eight times a year.
And they make a decision.
Are we going to add liquidity to the economy?
Are we going to leave the liquidity growth rate alone, or are we going to drain liquidity?
They meet and they make this decision eight times a year.
And they kind of hint at it even in that video.
This is not a, oh, everyone agrees.
It can get fierce in those meetings.
You have the inflation hawks, cut the money supply to zero, and you have the inflation
doves.
The economy needs help for God's sake.
Put some money into it.
And as a matter of fact, just this week that disagreement has rolled out and two of the
bank presidents are arguing in the news media for God's sake.
I mean, usually they're quiet and they have their differences when the door is locked,
but when they open the door, everyone's like, they're fighting it out.
They're duking out with competing interviews on news sites now, which is, yeah, that's
a little bit crazy that it gets to that point.
But there is often disagreement.
You have those who want to cut the money supply because they're still afraid that inflation,
the embers are just waiting to burst back out.
And then you have the other ones say enough is enough.
We have raised the discount rate more times than we ever did in history and the inflation
numbers are dead, so why are we still trying to cut the money supply?
So they can get really fierce.
However, there is a vote.
And once that vote is done, those 19 votes are counted, I'm sorry, those 12 votes are
counted and a decision is made.
Now if I understand, if I remember it right, if it's a 50-50 vote, the chairman decides
who's going to go.
Okay.
So whatever they decide, the district bank president of the Empire Bank sends a message
to the Empire Bank in New York.
And the message he sends, or she sends, goes to what is called the domestic trading desk.
The domestic trading desk, the DTD, is in the Empire Bank.
It's there.
That's why that one is more important than the others because whatever the Fed decides
at the FOMC meeting, it will be executed at the domestic trading desk in New York City.
Now this is not, when I say desk, the word desk in corporate, in corporate and government
lingo is not, you know, wow, I got a nice desk right here.
The desk is an official thing.
And this desk has many, many, I think hundreds of traders.
The manager of the desk gets the message from the FOMC.
Add liquidity or drain liquidity or leave the liquidity growth rate where it is.
That's what the domestic trading desk does is execute the orders of the FOMC conveyed
to them through the Empire Bank president to the desk.
Now if you follow that, the rest of it is kind of just that story of that swirling billions
and billions of dollars every day just like that all through the economy.
This is where it's happening.
Watch.
I'm trying to think, who looks like a desk trader?
Oh, no actually some of you do.
I can see you in New York City doing it.
Let's say you.
You're a desk trader.
Now the desk manager has given the orders.
He or she got it from her boss, the New York bank president.
Let's say drain liquidity from the economy and that message is sent to all the traders.
Do it.
So here's how it works.
You are a desk trader.
In your desk are tons of dollar bills and tons of T-bills.
Now treasury bills and dollar bills are almost exactly the same except for one important
feature.
Both of them are highly liquid and highly safe.
They are both good as gold to a certain extent.
Here is your bank, a normal happy bank.
Right there.
Now a bank will have in its vault dollars and T-bills.
It's the safest capital.
Every bank has to have this super safe capital and dollars and T-bills fill that need, fill
that.
So the bank has sort of a balance of dollars and T-bills and those are tier one capital.
What a bank has to have to show that it can stay in business.
It has other investments too like loans and stuff like that but this is the super safe
stuff the bank has.
So you the desk trader knows that you need to get money away from that bank.
Dollar bills.
You need to drain liquidity.
The way you drain it is to pull these dollar bills which are part of the federal funds
market.
So what you're going to do is I'm a bank president.
You call me ring ring, yellow, Al's bank and all you can eat, cheeseburger bar, may I help
you?
You say hi, you're the desk trader, hi I want to sell you some T-bills.
Oh okay, I guess.
So what you do is you then sell a T-bill to the bank and I, the bank president, send you
a dollar, send you some dollars.
You just drained liquidity from the federal funds market.
That's how it's done.
Now in a more advanced course, I mean I go through these details of these bizarre ways
that they pull this with T-bills, with repos and reverse repos and all this stuff but it
boils down to exactly this.
This is how it's done.
Every day the desk traders are working the banks following the orders of the domestic
trading desk management which got their orders from the Empire Bank president who got his
or her orders from the FOMC.
So there's this chain and it's like a machine.
It's not like something, well how do we do this today?
It's so automatic anymore.
It's just like pushing buttons.
The bank, the Fed just pushes a button and the bank buys a T-bill or something like that.
So that's how you would drain liquidity.
Now let's take it the opposite way.
Let's do it again.
Now remember the trader has dollar bills and T-bills.
The bank has dollar bills and T-bills.
This time your desk manager has said add liquidity to the economy.
Go, do it.
So you call me up, ring ring, hello, Al's Bank and Burrito House of Joy.
You say wait a minute, weren't you something else?
Change your menu.
Okay, try to concentrate.
Okay, here we go.
So what you do is you say I should like to buy some T-bills from you.
Well okay.
So in this case you send, they give up a T-bill and you send them money that goes into the
federal funds market.
That's how LMOs work.
That's how the Fed, its main tool of monetary policy, day in, day out, flowing money back
and forth, T-bills back and forth, exchanging them like this.
And on balance, and interestingly enough, you might want to add liquidity to the economy,
but you know what?
You might once in a while sell a T-bill to a bank.
Well wouldn't that take money out of the economy?
Yes, but it would also confuse the speculators who were trying to bet on which way interest
rates were going to go.
Because if you pull the rug out from under them by draining, that would cause interest
rates to go up.
I was expecting you to add liquidity which would make more money and therefore interest
rates in the federal funds market would go down.
So I would be speculating thinking I knew what you were going to do, but you might do
the opposite just to knock me out of the game for a minute.
It happens.
That's why right now you'll see, well if the Fed is going to hold the money, not going
to do anything, why do we see, I can't pull it up right now, but there are actually places
where you can see green arrow, add liquidity, red arrow, drain liquidity.
You can see times when you know damn well the Fed is draining liquidity, but you'll
see a green arrow.
What the heck?
Why are they doing that?
Because they're bluffing the traders.
The traders think that they're draining liquidity which would cause federal funds rate to go
up, other interest rates to go up, but if you add liquidity it will cause interest rates
to turn the other way and it will pull the rug out from under the speculators.
Something that happens.
There's a lot of gamesmanship in this, a lot.
I get confused.
Some of it's really complex strategies and all that, but anyway that's the basic outline
of how the Federal Reserve uses, these are again open market operations, OMOs.
They're done every day, just billions and billions of dollars every day flowing through
the banking system, flowing through the economy in these vast airwaves that almost no one
knows are happening and yet they are affecting our companies, our lives, our economy, and
our nation.
Most people don't have any idea that that's going on.
Now one last thing I want to tell you about, just a little kind of side part to this.
When I say money, money is a little bit more complicated than one might think.
There are actually different monetary aggregates and we divide them up based upon liquidity.
The first level, which almost no one talks about anymore, but it's really there, is this
M sub zero.
This is just the cash and currency in the economy.
Dollars and cents in the economy.
The amount of just pure money that people think of as money.
I think they call this, it used to be called the base, the base money supply, just what
people think money is.
Now the one that you usually see mentioned first though is M1.
This is the cash and currency, M0, plus demand deposits, in other words, checking accounts
at real banks, because that's pretty liquid.
I mean it's almost as good as money, a debit card and all that.
There's also a third one in there, I don't even write it up on the board anymore.
Another kind of very, very liquid money, but I haven't heard anyone use it in years.
Have any of you ever heard of travelers checks?
Don't leave home without them.
They used to be a really big thing, because if you were going overseas, you turn your
say $1,000 into 1,000 travelers checks, and they were accepted all over the world instantly,
and if you lost them or they were stolen, then you were reimbursed very, very quickly.
So they are technically still part of M1, even though they're hardly ever used.
Have any of you used travelers checks ever?
Like I said, I don't even write it up there, but it is part of M1.
Okay, let me do this.
The next one is M2.
Now remember, as I'm going down, I'm going into more illiquid stuff, more stuff that's
not easily converted to another asset.
M2, that's M1 plus negotiable order of withdrawal accounts plus small time deposits.
Now I mentioned this earlier in the course.
Now accounts are checking accounts at credit unions.
That's mostly what they are.
They actually look like checks.
They're mostly honored like checks, but technically a check from a credit union doesn't have to
be cashed by the credit union immediately.
Now if you go in there with someone's written you a check on a credit union for $100, they'll
say, well, yes, just ID, here it is.
But if you brought in a check for let's say $10,000 that was written on a credit union
and someone who had that credit union account wrote you that check, you go to a credit union,
they don't have to give you that $10,000 on demand.
They could tell you you have to wait.
So in other words, that perfect liquidity isn't there.
That's why now accounts are put in M2.
Now small time deposits, and forgive me if I don't know the exact amount, but I think
it's any CD certificate of deposit or something like that that is for $50 million or less.
So in other words, small time deposit.
Because I mean, if you got a CD, you try to, I want to turn that into cash, they'll charge
you a substantial interest penalty for early withdrawal.
You'll get burned.
So in other words, it's not highly liquid.
That's why it's in M2.
Now the last one is M3.
This is M2 plus large time deposits, these insanely huge things we'll never see, plus
euro money.
Now when I say euro dollars, I am referring to American money in the central banks of
foreign countries.
When you buy a Chinese toaster for $20, that $20 turns into foreign reserve money.
That country has to use that money back here in the United States.
It's highly illiquid, but it is vast.
It is a huge pool.
You buy a barrel of oil for $77, well, that's going to go maybe to some Arab country like
Saudi Arabia, and that's what the oil producing company will get the Riyadh equivalent of
the $70.
And that money in dollars, that $70, is then in the central bank of that country.
Those are called petrodollars, by the way.
But I use the general generic term, euro money or euro dollars.
Highly illiquid.
Let me show you one last thing.
About the crisis of 2008, the Fed's job is to control the growth of the money supply
so that it matches the real growth rate of the economy.
Now some years ago, I was one of the relatively popular bloggers on financial and economic
news on the internet.
And at that time, in 2000, about, started in about 2006, 2005, I was writing articles
warning that something very bad was going to happen to the economy because the Federal
Reserve, here's what was happening.
M3 was out of control.
The Fed can't control it.
That's just people buying and companies buying foreign stuff and sending our dollars to their
central banks.
So this thing was spiraling out of control.
It was so bad the Fed stopped publishing M3 in 2006.
They were so freaked out they didn't want everyone going crazy about how insane the
growth rate of M3 was.
And it was all because of the euro dollars, the money in other foreign banks, because
we were buying foreign cars, foreign oil, we were buying everything, so M3 was skyrocketing.
Even M2 was getting ridiculous.
So how did the Fed deal with it?
They cut the growth rate of M1, the money that households and businesses use every day.
They cut the growth rate of it down to zero.
So in other words, the economy was cruising along at about 2.5%.
Just like a car driving along at 25 miles an hour.
And then all of a sudden the liquidity, the M1, was cut to zero growth rate.
And of course, by September 15th, the economy collapsed.
It just buckled.
The entire banking system just buckled.
That was what caused the Great Recession.
There are all these talking heads, well, it was the housing market bubble, some bubble
crap again.
Or we were giving home loans to high-risk people.
How dare those poor people want to live in a house they own?
All kinds of excuses.
You look right here, there it was.
The growth rate of the money supply had been cut, of the M1 had been cut to zero even though
the economy was growing.
It didn't have enough lubrication, but liquidity to do that.
And finally it cracked.
On September 15th of 2008, we came within two hours, and I'll tell you about that maybe
next week if I have a minute.
We came within two hours of a financial apocalypse of the entire world.
ATMs wouldn't work.
You couldn't get your money out of banks because they had no money to give.
It was nearly a disaster.
It was enough of a disaster because we had, this led to the worst recession since the
Great Depression.
And the Fed has quietly made sure that hardly anyone knows that it was their inappropriate
reaction to the growth rate of M3 by using M1 to try to drag it down that caused it to
happen.
Notice that when the growth rate of M1 was above zero, the M3 was still skyrocketing
so by cutting M1 down to zero, they were barely denting M3's rapid growth rate.
That's how it worked.
Anyway, you have a quiz to take and then once you finish that, that will be all I have for
you today and I thank you.