The Fed is backed into a corner…
…and we’re eventually going to pay for their failed experiment. The Federal Reserve, our central bank, is tasked with several objectives which include conducting monetary policy, promoting financial system stability and supervising financial institutions. But what happens when the Fed fails to serve the public interest because it is too focused on cleaning up its own mistakes? And what happens when the Fed publicly admits they have no idea what drives inflation when their core tenet is to use monetary policy to manage inflation? What will be the result of decades of failed monetary policy that has encouraged Americans to take on record amounts of debt in hopes of economic and financial prosperity? Those questions will be answered in the years to come, but upon closer examination, it’s clear to me that the Fed has failed and they are going to leave our country and the world in a much worse situation because of their decisions.
This past week I asked myself how we got into this situation; a world of record high debts, record high asset prices, record low-interest rates and record low volatility. The answer lies within the decisions made by the Fed and global central bankers. When I asked myself how central bankers will normalize this situation without crashing the global economy, I couldn’t come up with an answer. Nobody really has an answer to what is going to happen, but for the first time in years, the Fed and other central bankers are starting to admit they may have made a mistake and are indicating they are clueless about how to manage economic forces.
I believe the Fed has backed themselves into a corner in an attempt to clean up their own mess of prior years and are quickly coming to the realization that they have screwed up. Unfortunately, it is you and me that will have to pay for their mistakes, but first, let’s explore how the Fed got us into this situation.
Following the dot-com bust and the 2000-01 recession, then Fed Chairman Alan Greenspan attempted to use monetary policy to lower interest rates to minimize the economic downturn. It worked. Alan would soon become known as “The Maestro” for his nearly flawless execution of monetary policy to end the recession. But like central bankers of the past, Greenspan’s Fed kept interest rates too low for too long which would lead to a huge housing bubble. This is no different than the policy mistake of the 1920’s Fed that kept interest rates too low for too long that ultimately lead to the Great Depression. Despite creating a massive housing bubble that would nearly collapse the entire banking system of the United States, Greenspan would step down as the Fed Chairman before the bubble popped.
Shortly before the housing bubble collapsed, Ben Bernanke would take over the helm of the Fed. Ben was the right man for the job because as a student of the Great Depression, Ben felt that he understood the policy mistakes that were made then and felt that he could avoid repeating them. At the same time, Ben believed he could use policy tools to eliminate recessions entirely. His narrative is that central banks don’t provide enough liquidity, or money, in times of financial crisis. Little did Ben realize when he took the reins of the Fed that he would soon have the opportunity to test that theory.
As the 2008-09 recession went into full swing it became apparent that the easy money policies of the Greenspan era Fed created a massive debt bubble. The debt was so big that it very nearly destroyed our entire banking system. To avoid a systemic collapse, Ben stepped in and began implementing a zero-interest rate policy and flooded the global economy with liquidity through three successive Quantitative Easing programs. Fortunately for Ben and the Fed, his plan worked. He kept the banking system from collapsing, kept the stock market from further crashing, and he managed to regain the confidence of the American public. Ben solved a debt problem by creating more debt.
Nobody bothered to ask why the Fed saved the banks, but given the alternative, printing trillions of dollars seemed like a better idea. After all, two of the Fed’s goals are to supervise financial institutions and promote financial stability and allowing the banks to fail hardly qualifies as promoting financial stability. Bernanke and his Fed did what had to be done. But nobody bothers to ask how we got into all that debt because fingers would quickly point back to the Fed. If it wasn’t for Greenspan’s Fed keeping interest rates too low for too long, there probably wouldn’t have been a housing bubble or a financial crisis.
Today we look back at what Bernanke did and say that he saved our economy. In actuality, he was just trying to cover up the mistakes his predecessor made! Had Ben allowed the banking system to fail, our country would have been thrown into a long, deep recession. Both the public and Congress would demand answers, which would squarely point back to the Fed. If the public ever figures out that the Fed and the fractional reserve banking system is a complete scam, then the Fed’s control of our money supply and power associated with that control, will end.
Most people think the Fed is a government agency, when in fact the Federal Reserve Bank is a privately-owned organization that has the sole control of creating money for the United States. The Fed is a member of the Bank of International Settlements (BIS), which is the privately owned central bank for central banks. Every couple of months central bankers from around the world meet at the BIS to discuss policy issues. Little is known about what goes on at these closed-door meetings because they are kept secret. The BIS does claim to be an open door organization, but only if you want information on meetings that happened more than thirty years ago. What few realize is that the monetary policy of the entire world is centralized and discussed at these secretive BIS meetings.
This is why that, following Greenspan’s folly, there was a coordinated effort by central bankers around the world to fix the problems created by the Great Financial Crisis. Once you understand that the control of the global money supply is controlled by the Bank of International Settlements, you begin to understand why they are willing to go to extreme measures to keep that scheme alive. After all, he who controls the money has all the power. The BIS and the central banks around the world hold all the power. Their policy decisions can create high flying expansions and deep painful recessions. It all starts to make sense when you realize that Bernanke’s decision to lower interest rates and print money was part of a coordinated effort to keep the central banking scheme running. And it almost worked.
There are two ways to solve a problem of too much debt: inflate the debt away or austerity. Austerity involves cutting back financially and paying down debt levels, which would lead to a prolonged global economic downturn. Since nobody likes austerity, the Fed and other global central bankers decided to inflate their way out of this problem. Few will notice this, but nearly every central bank in the world is targeting 2% inflation, which is likely a decision that came out of one of those secretive BIS meetings.
The problem with an inflation target, as I’ve discussed in the past, is that the Fed was hoping that an increase in asset prices would lead to an increase in wages. After all, an increase in asset prices and an increase in debt without an increase in wages will lead to a recession. At first, it worked and wages increased, but they quickly stalled out. Despite wage-growth slowing, the stock market soared to new heights.
What the Fed didn’t anticipate is the creativity of Wall Street and Private Equity firms. They took advantage of the Fed and used all the money flowing along with low-interest rates to engage in massive share buyback schemes and equity stripping schemes. History has shown that when corporations load up on debt to buy their stock back that their earnings and profits will underperform in the future. While it’s too early to see the full effect of all the share buyback schemes, in the coming quarters and during the next recession, increased corporate debt loads will lead to weaker earnings and profits.
The other unintended consequence of the Bernanke led Fed was a sharp drop in equity volatility. As more people buy stocks and hold them, volatility falls. Volatility, as I’ve discussed in the past, is a gauge of current liquidity and future price moves. In a low volatile market, such as this one, sellers are quickly met with buyers, which is a sign of a highly liquid market. Buyers and sellers can transact with ease in a low volatile market. Volatility also measures expected future price moves, and when volatility is low (it recently hit its historic all-time lows) future price movements should also be low. This sharp drop in volatility was a function of global central banks buying stocks, pension funds buying stocks, institutional investors buying stocks and the public buying stocks. Everyone went all in.
The reason everyone went all in wasn’t just because stock prices were rising, although that would be a good reason. Because the Fed’s policies led to a suppression of volatility, investor psychology shows that investors prefer to put their money in investments that go up, but don’t go down very much. If there’s any reason why investors dumped defensive assets, such as bonds and commodities to buy stocks, it’s because equity volatility is being massively suppressed. As a result, the Fed’s policies encouraged investors to take more risk and shift their investible assets into stocks. Even though stocks are normally risky, today they don’t seem that way because lately any downside moves are short in duration and are followed by prices moves up to new all-time highs.
Fortunately for Ben, he passed the torch to Janet Yellen who seemed well positioned to take on the challenge. It seemed like all Yellen had to do was continue the monetary policy path that Bernanke laid out and then start to tighten at the appropriate time. But Yellen, like many others before her, continued to keep interest rates too low for too long. More than eight years into this monetary experiment, the Fed is finding itself unable to meet its inflation targets. Even worse, it appears the economy is weakening from its already fragile state. At her last press conference, Yellen made multiple mentions that she doesn’t understand inflation or the forces that cause inflation. Perhaps fortunately for her, Yellen’s term is up in February and with any luck, she might find herself replaced before the economy comes crashing down again.
Let’s recap how we got here. In 2000 the dot-com bubble burst as part of a normal business cycle recession. The Fed lowered interest rates that led to a credit bubble. The credit bubble burst in the housing market which coincided with another business cycle recession. The Fed lowered rates again and began injecting mass amounts of liquidity into the global markets, which created an asset bubble. That asset bubble is now likely the largest in history which has also led to a [short] volatility bubble.
Based on historical business cycles, we are in the third-longest expansion and soon will be the second longest. When the next recession happens the [short] volatility bubble will unwind, which will be followed by a crash in asset prices (to unwind the asset bubble), which will then trigger a credit crisis (to unwind the credit bubble) and lastly, we will have the normal business cycle recession. All this will come at a time when investors have one of the largest, if not the largest, exposure to risk assets in history.
What I don’t understand is why investors over the last year are so confident in the Fed. Throughout history, every attempt to create economic prosperity by printing money has failed, meaning the probabilities that the Fed will successfully pull this off are close to zero. Sadly, the financial future of most retirees will be destroyed by the Fed’s policies. I hope that I’m wrong, even though history shows I won’t be because the aftermath of all these bubbles unwinding will likely be worse than I can even imagine.
Video Topic of the Week – Smart Money’s Real Time Data
Recently the mainstream media started running articles on a potential “melt up” in stocks. I believe this was a propaganda campaign started by the smart money hoping to incite more animal spirits. What’s interesting is how the smart money can now use social media and the Internet to gauge the public’s response.
Chart of the Week – S&P 500 Price-to-Sales Ratio
Now at the second highest level in history, just below the prior peak. Investors are paying a huge premium to buy stocks hoping they will go higher.
Portfolio Shield™ Update
The October 2017 Morningstar® investment detail report is linked below.
Weekly Sector Commentary
Broad Market / Economy
We are now two weeks into Quantitative Tightening where in addition to raising interest rates, the Fed is now unwinding its $4 trillion-dollar balance sheet. To the best of my knowledge and research, no central bank has ever attempted to deliberately unwind its balance sheet. What does that mean to you and me? Simple, if Quantitative Easing was supposed to boost inflation and asset prices, then Quantitative Tightening will have the exact opposite effect.
That means we are about to enter a deflationary cycle. Asset prices and interest rates should fall. This validates the “topping” pattern I’ve pointed out in U.S. Treasury yields since the election. It also validates that the stock market, which has been a beneficiary of the Fed’s policies, should start to contract.
What is going to be interesting is what will happen to stock prices when everyone runs to the exit. After all, the Fed’s policies have pushed everyone into risk assets and based on trading volumes, there aren’t any buyers left.
If you’re wondering what continues to drive equity prices higher nearly every day, it’s not because there are very many buyers. A quick look at trading volumes tells us that when trading volumes plummet, as they have, fewer shares are exchanging hands each day. Fewer shares being exchanged means there isn’t much interest in the markets.
What I find interesting is over the past week or so the mainstream media started talking about “blow off” tops. A blow-off top is a condition where a flood of money comes in at the top of the market, usually by the public, that allows the big money investors to sell at the peak. If you were to look at some charts of blow off tops over the years, you’d notice one distinct attribute. Each and every one of them has a massive spike in volume. That makes perfect sense because a blow-off top only occurs when public interest in stocks is so high that they are willing to buy with every dollar they can find. As they buy and the big money sells, you get an end-stage surge in stock prices and volume that markets the end of the bull market.
Shortly after the mainstream media picked this up, newsletter services, magazines, radio shows, blogs, twitters and whatnot blew up with people talking about blow off tops. This is extremely interesting because I believe the big money is using the media in an attempt to create a blow-off top. Thanks to the Internet and all the analytics associated with it, the big money investors are able to get a real-time information on the public’s reaction.
Since this media campaign began, trading volumes have continued to fall and Internet searches for “blow off” top have surged. Meaning the public is interested, but they aren’t buying. For the moment that tells us that the public is already fully invested. Good information.
Back to the original questions. Why is the market going up? Because volatility is being compressed. Rather than buy stocks the big money is very short volatility which can push the market up even in the absence of buyers. Suddenly this makes sense! The big money isn’t out of the market, but they want a blow-off top. Since they aren’t getting it, they are pushing volatility up to use it as a smoke screen to sell their equity positions.
The evidence is all over the place. On Monday, after markets closed, there were huge spikes in volumes across various ETFs, but not all of them. Notably, there was a huge spike in the S&P 500 (which I believe is selling volume) and long volatility (which I believe is buying volume). If that is true, we are starting to see the big money position themselves to start the next bear market. The only reason to start the next bear market is that they have exhausted all the buyers. Makes perfect sense!
The Fed is officially tightening, even though they started raising interest rates back in December 2015, it would turn out that the reinvestment of the dividends of their $4.5 trillion-dollar bond portfolio would more than offset four rate hikes. It’s important to understand the relationship between monetary policy and interest rates.
When central banks ease they do it to create inflation. When interest rates rise, as they should during times of inflation, bond price fall. When central banks tighten, as they are now, it leads to deflation. When there is deflation, interest rates fall.
I can easily make the argument that going into the election that the big money was trying to buy bonds because they knew the Fed was heading towards tightening. But after Trump won, everyone rushed to sell their bonds out of inflationary fears over his economic policies. Sure enough that caused interest rates to shoot up, but they stopped going up because the big money was back buying bonds. They did that because they know when central banks tighten that interest rates and asset prices go down.
If you want to know what I believe we are seeing a topping pattern in interest rates and why the big money is buying Treasuries, it’s because deflation is coming and relative to stocks, bonds are cheap.
When you tack on top of deflationary forces that there will be a credit crisis from all the debt, just like in 2008, then you have a strong macro view of why bonds are one of the places you want to be. Not
International / Emerging Markets
With the Bank of Japan and European Central Bank continuing to keep monetary policy loose, foreign markets should outperform domestic equity markets. That is until the BoJ and ECB begin to tighten monetary policy. Japan has made it clear that they aren’t going to tighten, which is why their economy is seeing inflation. It’s not Japan I’m concerned about, it’s Europe.
The ECB is running out of bonds to buy under their version of Quantitative Easing, which could be a problem if they decide to end the program. We haven’t seen what happens when a county (or currency union in the case of Europe) goes from negative rates to neutral. I have a hunch it will blow up in their face. While I want to be long foreign equities, even if it’s a small position, I don’t see how foreign equities can rally much if the domestic stock market starts to fall.
Regular readers know I have had a recent interest in the energy sector due to the potential of oil rising to $60 per barrel. Even though OPEC is trying to cut production, everyone knows this won’t work. My view on oil is starting to change and I think that’s worth a bit of exploration.
According to classical chartist Peter Brandt, oil is in a topping pattern. From a supply perspective, the world is flooded with old. Looking at futures contracts, speculators are very long oil while producers are very short oil.
Let’s focus on the big money investors. Oil is trading around $50 per barrel and seen highs over $100 per barrel with lows in the $20’s. Why would the big money be selling, assuming Peter’s interpretation is correct? The big money sells because they almost always buy low and sell high. So they must feel that at $50 per barrel that prices aren’t going up much more.
Following that narrative, they must believe oil prices are going to fall to a point where they will buy again. Why do they think that? It’s not just that oil prices fall during a recession because demand falls. It’s also not because supply is high because that would bring prices down. This is about future supply and the big money must think future supply is going to fall. I think they’re right.
I have been told from people I know that many oil producers aren’t reinvesting as much money into exploration and that there could be a short supply of oil in the future. This is a very logical reason to support higher oil prices in the future.
But what most people don’t realize is that when the stock market falls that it’s going to trigger a credit crisis. Bank lending is already contracting at a rate not seen outside a recession. Oil companies, in particular, are one of the largest issuers of high yield debt. High in yield due to the potential that investors might not get their money back. I also know that some of the largest oil companies have been engaging in stock repurchase programs, rather than putting money into their underfunded pensions or into exploration. That’s what makes this interesting.
In a credit crisis, credit dries up, meaning those who need credit to function on a daily basis might not be able to get it. When you factor reduced demand due to a recession when corporate balance sheets are loaded with record levels of debt, you can draw the conclusion that there will be companies in the energy sector that go out of business. I’m not suggesting that the majors will fail – don’t interpret my view that way. What I’m suggesting is that due to too much debt and an inability to access credit markets that companies along the supply chain will fail. That alone could cause a disruption in supply when the global economy turns around.
Future supply disruptions mean that future prices are likely to be higher. Based on that narrative, any investment in the energy sector at this point is likely short-term at best.
I’ve said the dollar has been in a major topping pattern for more than two years. Some take the position that the dollar is going to rally while others, myself included, think the dollar is set for a big fall.
The bullish argument is that during the next recession the dollar will rally because it is perceived as a safe haven. That’s historically accurate.
However, that doesn’t mean the overall demand for dollars is weakening. Most dollars are created under the petrodollar system. When oil prices are at $100 per barrel more dollars are needed than at $50. If oil does fall, then there will be fewer petrodollars created. Lower oil prices mean lower dollar demand.
I think the reason the topping pattern is taking so long is that of the sheer number of dollars that exist in the system. The mainstream media has been saying how all of Trump’s policies are dollar bullish, which is backed up by many traders. Sometimes that is all you need to know.
If a large holder of dollars wants to sell before prices fall, then they need to sell people on the idea of owning dollars. While there may be a bounce in the dollar and a bit of a rally during the next recession, I think the dollar is topping.
Which makes the oil story even more interesting. If there is a dollar rally, then that will push oil down due to the inverse relationship between the dollar and oil prices. But if the dollar makes a major move down, then that would be bullish for oil. And a great opportunity to buy oil would be after all the long speculators are flushed out and the recession hits when oil prices are low.
Suddenly the bigger picture here looks compelling.
Gold sentiment closed out the week at 47%, which in prior sentiment rallies has been an area of contention and frequent reversals. December gold futures tagged $1,300/oz. again, for the fifth time. My recent narrative was that the fifth time will break and the rally will begin. I’m not as convinced due to the overall weak volume with this price move. If it breaks, then we’ll want to buy, but I have a hunch that there might be one last pullback.
Both gold and silver miners started to move over their key 50 and 100-day moving averages. This was a sign I’ve been looking for. Unfortunately, every other day this week involved sellers. Rallies generally don’t begin with selling. Silver continues to lag behind gold, and gold rallies are usually led by silver. We’re very close to beginning our purchase program here.
I believe in the next cycle that gold and silver miners will lead, followed by agricultural commodities, then U.S. Treasuries and last, maybe the U.S. Dollar.
Every ten years or so commodities go through what is referred as a “super cycle” where prices shoot straight up. I believe that this is coming soon. This is the same supply and demand dynamic that’s going on in oil, but commodities are ahead of the game.
Right now there is record supply and record demand which pushed commodity prices down. When you look at a chart, you can see commodity prices have been consolidating for many years. Prices are low and not moving lower, so why buy?
Demand isn’t expected to fall, but supply could. Farmers rely on the credit markets and since they are sitting on record inventories that they can’t move, their dependence on credit is probably high. During the next recession, it’s probable that farmers will succumb to high debt levels and the inability to get credit to plant, maintain and harvest their crop. That future supply disruption, even if temporary, would cause commodity prices to soar.