POMO, TOMO and Stock Returns

A reader hypothesized that the Federal Reserve uses Open Market Operations repurchases to stimulate, or prop up, the stock market. The hypothesis supposes that private parties, such as prime brokers, use the funds released by these repurchases to buy (highly leveraged) stock futures contracts, immediately attracting arbitrageurs who simultaneously short futures and purchase stock indexes. Trend followers then pile on. The Federal Reserve states that open market operations regulate “the aggregate level of balances available in the banking system,” thereby keeping the effective Federal Funds Rate close to a target level. The operations are predominantly repurchases, whereby the Federal Reserve provides liquidity. Do these Permanent Open Market Operations (POMO) and Temporary Open Market Operations (TOMO) affect the U.S. stock market? In other words, do the managers of POMO and TOMO transactions act as a “Plunge Protection Team?” Using accepted Treasuries repurchase transaction data for POMO during 8/25/05 through 5/20/11 (323 transactions) and TOMO during 7/7/00 through 5/20/11 (2,590 transactions) and contemporaneous daily and monthly closes of the S&P 500 Index, we find that: (more…)