The Fed Tightens
Last Wednesday the Federal Reserve (or Fed) made a major announcement that they will begin unwinding their $4.5 trillion-dollar balance sheet that is made up of mortgage-backed securities and U.S. Treasury bonds. The plan is to start by selling off $10 billion per month of those holdings and increasing the amount in 2018, with the goal of reaching $50 billion per month in 2019. The Fed is choosing to do this despite an overall weakness in the economic data, as evident by the fact they didn’t raise the Federal Funds rate and they downgraded their projections for future rate hikes.
To the best of my research, this will be the first time a central bank has attempted to sell off its holdings. The reason this is interesting is that the Fed has a perfect track record of creating a recession or soft landing every time they contract the money supply, which happens when the Fed raises rates and sells off their bond portfolio. What’s even more interesting is that the Fed’s decision comes at a time when households own the second highest percentage of stocks, as a percentage of total financial assets, in history. The public is hoping this ends well, but history suggests the outcome will not be in their favor.
The Fed seems uncertain about their decision to begin unwinding their balance sheet, but they are pressing forward. Inflation data has been stubbornly under their 2% target and the Fed admitted that it is a “mystery” as to why inflation remains so low. At the press conference that followed Wednesday’s announcement, Yellen admitted that “[she] cannot say that the Committee clearly understands the causes of that,” in reference to why inflation remains low. It’s frightening that the organization that is in charge of managing inflation and deflation for our country seemingly has no clue that the main reason inflation remains low is because energy prices remain low.
The other reason inflation remains low is because the United States exports inflation. I know that sounds strange, but to meet the demand for dollars under the petrodollar system, the United States must print enough money to facilitate global trade. Since those dollars aren’t circulating around our domestic economy, they don’t lead to inflation. However, if those dollars were to ever come home, they would lead to a huge spike in inflation. Over the past eight years, the Fed has printed trillions of dollars, some went overseas and the rest has been invested into the stock market, neither of which led to domestic wage growth or price inflation. Despite that, the Fed is certain that the inflation they are trying to create is right around the corner.
According to Fed models and experience, they believe a tightening labor market will eventually lead to wage growth and price inflation. That belief is what led the Fed to their decision to begin unwinding their balance sheet, even though they missed their inflation targets and they have downgraded their growth targets. Despite all of that, the Fed remains hopeful that inflation is coming. Although I’m not sure how they expect inflation to rise when the data shows that when the money supply contracts, that inflation, and asset prices tend to fall with it.
The goal of Quantitative Easing was to expand the money supply and boost asset prices – which includes raising stock prices, housing prices, etc. The Fed already started tightening by raising the Federal Funds rate in December 2015, but that was negated by a weakening dollar and continued easing by foreign central banks. Now that the Fed is embarking on Quantitative Tightening, asset prices should fall. Yet what I find remarkable is that Wall Street shrugged off the Fed’s announcement as if they don’t believe the Fed will actually tighten the money supply.
Regardless if the Fed delivers, the money supply is tightening because bank credit for both businesses and consumers are contracting. Credit cycles follow a similar pattern: the Fed eases the money supply to expand the economy. Banks lend to businesses and consumers, which expands the money supply. Debt levels grow to an unsustainably high level. Banks, along with rating agencies, restrict or contract the amount of credit being issued, which tightens the money supply. The Fed then begins to raise interest rates and unwind their balance sheet to combat future inflation. The economy enters a recession. As you can see, we are in the very late stages of this cycle.
For a while I’ve been saying that the next recession with be the worst in our lifetime. The reason I have stated that is that not only are we going to have the normal recession that occurs every six to eight years, but when that recession happens, we are going to uncover problems from the 2008 recession. The last recession was never allowed to fully resolve itself because the Fed reacted and solved a problem created by too much debt by stacking on even more debt. Once the first layer is uncovered, then the layer from the last recession will start to appear. And there won’t be a recovery until all the bad debts have been dealt with. Nobody believes you can solve a debt problem with more debt, except central bankers. It’s no different than hiding rotten food inside good food and expecting the rotten food to turn good. It just doesn’t work that way. Ultimately this is why the entire system needs a recession because that’s when all the bad debts and bad decisions are purged from the economy.
If you’re wondering why we covered up bad debts with more debt, look no further than former Fed chairman Ben Bernanke. Ben was a student of the Great Depression and he concluded that the mistake the Fed made in the late 1920’s was to allow the money supply to fall. In 1929 the Fed allowed banks to fail and when they did, the money supply dropped by one-third. That happened because when loans default and the underlying assets later sell for a lower price, money is removed from the system.
For example, let’s say I borrow $1,000,000 to buy a piece of land, and for the sake of this story, let’s say I am the only borrower of this bank. At the moment the loan is created, $1,000,000 is added to the money supply. Now let’s say I immediately default on the loan due to an inability to make the payments. Because I am the banks only customer, the bank ends up failing as well. The property then goes to auction where it sells for $600,000. When it sells, $400,000 is removed from the money supply. ($1,000,000 original loan less $600,000 for the new loan to buy the property equals a net loss in the money supply of $400,000.) That’s essentially what happened during the Great Depression.
To prevent the money supply from collapsing like it did during the Great Depression, Bernanke and the Fed decided to print money and recapitalize the banks. By doing so, they prevented a massive collapse in the money supply. The only way this works is if there is enough economic growth and inflation to wash away those old debts. Since we haven’t seen economic growth or inflation, it suggests that the next recession will be deeper and longer than normal to deal with the imbalances created over the last two business cycles.
This has to happen because the Fed choose to print money to get out of the last recession rather than letting overextended businesses and consumers fail. The Fed has created zombie consumers and businesses, which is a person or business that has enough revenue to pay its existing bills that would otherwise fail if interest rates were normalized. In the next recession those who are failing today will fail and those that should have failed back in 2008 but weren’t allowed to, will also fail. The economy is going to be crushed by an unsustainable amount of debt.
I realize that very few people agree with my view, considering nothing bad has happened since the Fed embarked on three successive Quantitative Easing programs. After all, Japan, who created the concept of Quantitative Easing, has been doing it for 27 years without any ill effects. Keep in mind, 27 years later, the Japanese stock market is down 50% from its all-time highs and the ten-year Japanese Government Bond (JGB) is yielding next to zero percent. The only reason Quantitative Easing has worked in Japan is because the Japanese own over 80% of their government debt, meaning their citizens are buying the paper their central bank is printing. If the Japanese didn’t buy their debt, then the system would collapse. Someone must buy the debt in order for the central banks to keep printing. Whereas in the United States, very few investors here buy U.S. Treasuries, which will need to change as long as Fed attempts to print its way out of our problems.
I realize you may think I’m pessimistic that we can print our way out of this problem. I hold that view because throughout history governments have attempted to print their way out of their financial problems and it has never worked. My view is just based on probabilities, and looking at history, the probability of this money printing scheme working is extremely low. This only leaves the question; how bad will the next recession be and how long will it last?
Video Topic of the Week –
The answer to mystery behind the Fed’s inflation problem.
Chart of the Week – Excess Reserves vs 10-Year Treasury Yields
When the Fed tightens many expect yields to rise, but history shows the opposite.
Portfolio Shield™ Update
Based on recent price moves in small caps I expect the algorithm to shift back to a full equity allocation next month.
Weekly Sector Commentary
Broad Market / Economy
As hedge fund manager Erik Townsend said in his podcast this week, this market is making a lot of smart people look dumb. As equity markets drive higher, those who are looking at the hard economic data, such as myself, can’t explain what is driving people to push equity prices higher.
What I can tell you is that there are many like Erik who believes the S&P 500 may not peak until it reaches 2,800 to 3,000 points where it would experience what is referred to as a “blow off top.” That is the point where investors are piling in like mad because they are afraid of missing out. That’s also the point there is no missing out because long-term investors are busy cashing out.
Usually, blow off tops occur under increasing price moves and increasing trade volumes. Trade volumes increase as investors, mainly the uninformed public, buy in droves. The probably when that narrative is that the public has the second highest ownership in equities in history while their disposable income continues to fall. And with Affordable Care Act (ACA) premiums expecting to rise significantly next year, that alone will curb the publics ability to invest in the market. I’m not convinced there will be a blow off top, but there could be.
The other interesting thing this week is that for some reason I can’t explain is that hedge funds have a record number of short positions against volatility. They are deliberately trying to push the market up by shorting volatility. Why? Not sure, but it would be like dancing around the rim of an active volcano. After all, a well-placed missile from North Korea could spark a global rout in volatility. I have no explanation for this other than they are trying to drive the market higher in any way possible.
The consumer confidence data remains optimistic, which at this point can only be on the hopes that President Trump and Congress can pass a retroactive tax reform package and possibly a healthcare reform package by the end of the year. The data shows that many Americans are living paycheck to paycheck, so they are hoping for any kind of financial relief. If history is a guide, the probabilities are low that anything meaningful will get passed, if anything at all. I can only wonder what will happen to the markets when consumer confidence falls.
Other than Fed speakers largely admitting that they don’t know what they are doing, the major news of the week to drive stock prices was the potential for tax reform. Notably, this is the same news that has been sold to investors for nearly a year, but it works. Sentiment on the S&P 500 is divergent from price, meaning investors aren’t as bullish as the index suggests. Trading volumes continue to be weak.
Yields jumped this week in overnight markets as Asian investors sought to unload Treasuries. When big gap moves happen to the downside, it’s usually done based on news (there wasn’t any in the overnight markets) or to flush out all those with stop losses. Despite a fairly large gap move, bond prices didn’t plummet after the move. What this tells me is that those who own bonds feel very strongly about their position. And they should, when the Fed tightens, yields usually fall.
Bond prices settled near two key long-term weekly moving averages. If prices hold near these levels, it will serve as confirmation that the upward trend in bond prices (downward trend in yields) is still intact.
Bond sentiment closed the week at 50%, which is a key level. When sentiment falls below 50%, prices usually follow.
International / Emerging Markets
Nothing much going on in these markets this week.
I believe there’s a case for higher oil prices and if that is true, then the producers and explorers should benefit. After tagging a key weekly moving average, prices backed off. I’m looking for a potential inverse head and shoulders pattern to establish the right shoulder before taking any positions in this sector.
Crude sentiment recently peaked at 81%, which has been a peak in sentiment back in 2015 and 2016. If sentiment is correct, then this adds to my narrative.
Sentiment on the US dollar surged out of the dumps to 50%, which has been a strong level of failure in the past. There are lots of good arguments for a strong and weak dollar. I think the macro trend is weak, but I’m not putting past a shorter term move up that would bring gold down.
Gold sentiment dropped to 37% from a recent peak of 80%. Gold sentiment tends to fluctuate and drag prices along. If you watch the video portion, you will know I am looking for confirmation in both gold and silver miners (with a current bias towards silver) to serve as confirmation that the metals are beginning a secular uptrend.
The plan is to buy both gold and silver miners and use stop losses as I build into the positions. With China closed for a holiday next week, it could lead to the final drop in gold and silver that I’m looking for.
The most underloved sector in the market continues to find buyers. It closed out Friday on strong volume. Unless prices break above the highs set of the past couple months, I’ll be looking to sell the next rebound.