Weekly Economic Update 11-03-2017

The Fed is Draining the Swamp

There’s a phrase that goes around Wall Street trading desks that says, “Don’t fight the Fed” which translates to don’t fight ‘liquidity’. Liquidity, in stock market terms, is like the tide. During high tide, when water (or liquidity) is abundant, ships can come and go out of port with ease. During low tide, when water (or liquidity) is scare, ships run the risk of running aground. This is what makes liquidity so special because it is what makes the markets move.

Liquidity is also the reason markets can fall on when good news occurs or rise when there’s bad news; it just depends on how much liquidity is out there. Starting in October 2017 the Fed is draining liquidity at the fastest pace since the last recession and yet at the same time, investors have chosen to “fight the Fed.” Depending on the outcome, the decision to stay invested in risk assets as the Fed drains liquidity could be the biggest financial mistake investors make in their lifetime.

As I have discussed in the past, money is created through the banking system when new loans are originated and when the Fed buys bonds on the open market. When the money supply, or liquidity, grows faster than the economy, it causes asset prices to increase in value. Asset prices have rapidly increased in value since the Great Financial Crisis in 2008-09 because the Fed injected too much liquidity into the economy. To avoid the inflationary effects of overprinting, the Fed has decided to start draining that liquidity out of the economy.

Starting in October the Fed began draining liquidity at a rather slow rate of $10 billion per month. Given their balance sheet is about $4.5 trillion, $10 billion is a very small amount. Unfortunately, there isn’t any real-time data available to show if the money supply is falling, since what data is available on the money supply is lagged by a couple weeks. So far it would appear that there’s hasn’t been any negative effects, because the economic data and surveys have been at record high levels. That is because most of the economic data is from a prior month or quarter, so it should be at very high levels to reflect the high amount of liquidity.

What I recently concluded is that there is real-time information on liquidity and based on it, the effects of the Fed tightening are lagging the economy by a little more than three weeks. If my assumption is correct, then this past week is the first week the economy has felt the tightening effects of the Fed. That also means that with every passing week, economic conditions should continue to tighten until the system breaks. How long it will take for the economy to break will be determined by the amount of leverage in the system. Just like with 2008, nobody knows how much leverage is out there until it fails.

To help you understand what liquidity looks like, imagine a vacuum cleaner stuffed full of money with the motor on reverse. Money is flying out of the canister and going everywhere. This is what Quantitative Easing 1-3 looked like. When QE3 ended the Fed started to raise interest rates, but they left the vacuum on low. But money was still coming out at a rate faster than they were tightening. Starting in October the Fed has switched the vacuum back to normal mode and is now sucking up those dollars at a low rate. Starting in January the Fed is planning on increasing the speed at which it ‘sucks up’ liquidity to a rate two times faster than the current rate and in April, it will increase to a rate three times faster than it is presently.

You might be wondering why the stock market and asset prices have continued to rise despite the Fed attempting to reign in the money supply. The answer comes from the public, who after eight years of watching stocks go up, finally decided to join the party. When a person exchanges money for a stock (or anything else for that matter), that money enters the economy. Even though the Fed was trying to control inflation, the public caused inflation to rise faster than the Fed expected because they were and are draining their bank accounts to buy risk assets. This is why asset prices continue to rise as the broad economy weakens. There’s new money in the money supply, but it’s not circulating around to create prosperity. Money that goes into the stock market is money that has gone to die.

The only way this game can continue is if there is more new money entering the system faster than the Fed is vacuuming up. Since the data suggests the average American is nearly broke, it doesn’t appear that it can. If you were wondering why Wall Street is so focused on President Trump and his policies, it’s because Wall Street loves liquidity. Rising liquidity and asset prices generate huge profits, which Wall Street doesn’t want to give back any sooner than they have to. This is also why Wall Street is so focused on tax cuts, deregulation, healthcare reform and higher oil prices because those can increase liquidity, even if only for a short period of time.

Even if Congress is able to pass simulative legislation it will only be temporarily bullish, because the Fed will likely respond to any increases in liquidity by raising interest rates. The real issue isn’t the showdown between liquidity and Wall Street, it’s how much leverage is propping the system up. Unfortunately, nobody knows, but I have a strong suspicion that there is a very large amount of leverage hiding in the system that is just waiting to explode.

What we know is that liquidity is being provided by every major central bank excluding the Federal Reserve. The European Central Bank (ECB) has talked about tapering its bond purchases, but not until sometime later next year. What we don’t know is if their liquidity will flow much into the United States. Since there aren’t any historical points to reference back to, because there’s never been this much money printing in history, there’s no way to know for sure if their liquidity will continue to boost U.S. asset prices.

As far as the United States goes, we know that the Fed is unwinding their balance sheet at a rate of $10 billion per month that will increase each quarter, starting in January, by $10 billion per month until it caps out at $50 billion per month. It is expected then to hold at $50 billion per month until the Fed unwinds its balance sheet. We know that the Fed has hiked interest rates four times and is expected to hike rates one more time in December. We also know that the post-election rise in interest rates, as expressed by the 10-year Treasury yield, also act as a drain on liquidity. And last, but not least, we know the dollar is starting to find strength after falling nearly 10% from its recent peak. With the Fed vacuuming up dollars, the dollar should continue to rally, and a strong dollar is a drain on liquidity. As you can see, there are four different vacuums draining liquidity from the economy.

What this tells us is that the economy and asset prices should start to contract. I don’t believe we will see that in the economic data until December because in December we get a report on November’s economic activity. In the meantime, we should start to see weakness in the equity markets and a continuation of the rally in bonds. While it’s entirely possible that this equity market rally will go on forever, investors should heed the warning and not fight the Fed. Every drain in liquidity has led to a correction in risk assets or an all-out recession. It’s simply a case of following the money.

Video Topic of the Week – Liquidity

A primer on why asset prices tend to plummet when liquidity is drained from the system.

Chart of the Week – Service-Producing Less Goods-Producing Payroll Growth

The labor market continues to flash warnings of a recession.

Portfolio Shield™ Update

I improved the Portfolio Shield™ algorithm. Rather than swap one of the equity funds for a Treasury bond fund, the algorithm now holds the three equity positions at all times and it adds the bond fund to the portfolio when equity markets become volatile. This adjustment has improved its back-tested returns, which is impressive considering there isn’t a strategy like this anywhere else. The new strategy will be implemented immediately, and future reports will reflect the new algorithm.

I also wrote an algorithm that can generate an algorithm to assist me with creating new strategies. As I mentioned I have plans to create a strategy that rotates based on the money supply. Hopefully, I’ll have time to work on that in the next couple weeks.

Weekly Broad Market / Economy Commentary

I mentioned last week I would make some comments on the recent back-to-back 3% GDP numbers. At face value, they look great until you look at the Personal Savings Rate which is now at the lowest level since 2008. What this shows is that consumers are spending down their savings to keep things afloat until some sort of financial relief comes. The only question remains is how long can the consumer hold out before the fold.

As far as this month’s payroll report goes, the big concern is that wages growth actually fell for the first time since December 2014. Given the average American has less than $400 for emergencies, this isn’t a good sign. In order to service all of the debt and to keep asset prices elevated, wages need to grow.

When you read that average hourly earnings contracted on a year-over-year basis, that’s not a positive sign. Add on that the personal savings rate is at the lowest level since late 2007 and you start to understand that the consumer is spending their savings to keep the economy afloat. With savings dwindling, that trend can’t last forever.