When the Dam Breaks
In 1931 six companies began work on the Boulder Canyon Project. It would become our country’s largest dam, designed to control the mighty Colorado River. Five years later, with the help of 21,000 workers, Hoover Dam was completed early and under budget. The purpose of a dam is to control liquidity and Hoover Dam does it well. Behind the dam is Lake Mead, the world’s largest reservoir which holds 10 million gallons of water.
Just like Hoover Dam is designed to control water, the Federal Reserve’s job is to control the money supply. After eight years of building a huge reservoir of money to reignite our economy, the Fed has begun draining liquidity. Most people don’t understand what this means, but falling liquidity will have repercussions on asset prices and the economy.
Let’s examine the various ways liquidity can be drained from the economy and assess which ones are adding or subtracting liquidity today.
The Fed’s policies are the primary driver of liquidity. One of their preferred methods to control liquidity is by adjusting the Federal Funds rate. The Federal Funds rate is the bank overnight lending rate, which is the amount of interest banks can charge each other for an overnight loan to make sure they are meeting the minimum daily reserve requirements. When the Fed lowers the Federal Funds rate it increases liquidity and when the Fed raises the Federal Funds rate it decreases liquidity.
Starting in December 2015 the Fed began raising the Federal Funds rate from zero to one percent and they are expected to raise rates one more time before Jerome Powell takes over as the Fed Chairman in February. A rising Federal Funds rate disincentives banks from lending, which is evident by a drop in the bank lending growth rate since 2015. Since the Fed has indicated they are going to continue hiking the Federal Funds rate, the growth rate of bank lending should continue to fall and eventually contract.
When the Fed starts to hike the Federal Funds rate it’s usually a signal to Wall Street that the economy is overheating, and that inflation is about to rise. Bond prices tend to fall when inflation rises, so bond owners begin to sell their bonds when inflation starts to rise. This leads to an increase in market-based yields, or interest rates. When interest rates rise they also have the effect of removing liquidity from the market.
While the rise in market-based yields can persist for more than a year, on average, seven months following an increase in yields, yields gives way to the tighter liquidity conditions and begin to fall. For the past thirty-five years, each period of higher interest rates has been followed by interest rates falling to a new all-time low. The current rise in market-based interest rates has gone on for twelve months now, which means interest rates are more likely to fall. This is an important factor because interest rates react to liquidity. Interest rates rise and fall with liquidity, and since liquidity is being removed from the economy, it is more likely that interest rates will fall.
Bank lending is the largest contributor to liquidity or the money supply. When a loan is funded, money is added to the money supply and when a loan defaults, money is removed from the money supply. The other critical factor to understand is that every time a loan payment is made, money is removed from the money supply. Meaning to increase liquidity, banks need to fund an ever-increasing amount of new loans to offset the payments coming in from existing loans. For that reason, banks hold most of the power when it comes to expanding or contracting liquidity.
Back in December 2015, the Fed started to reign in bank lending by raising the Federal Funds rate, but the banks already began to contract lending growth. Since then, the growth rate of bank lending on a year-over-year basis has nearly turned negative. More notably, the growth rate of bank lending has recently fallen below the Consumer Price Index (CPI) or rate of inflation. This is significant because each recession in the past thirty-five years was precipitated by the rate of lending growth falling below the rate of inflation.
The fall in the bank lending growth rate isn’t just a domestic problem. Foreign banks also create dollar liquidity and back in April lending outright contracted from year-ago levels. When bank lending contracts or the lending growth rate falls below the rate of inflation, it drains liquidity from the economy.
The purpose of removing liquidity from the global economy is to reduce the number of U.S. dollars that are circulating. As dollars are removed, the value of those that remain tends to rise. When anything is increasing in value, those that own them tend to hold on to them longer. The same is true for the dollar. As fewer circulate and the dollar rises in value, those that have dollars are less likely to spend them, which also acts as a drain on liquidity. After falling nearly 10% this past year, the dollar appears to be reversing course and should reduce liquidity conditions as it rises.
The largest contributor to liquidity was the Fed’s Quantitative Easing program that swapped dollars for bonds. The Federal Reserve printed $4 trillion after 2008 in an attempt to bring the economy back to life. While experts disagree on how effective the program was, what it did do was dump a huge amount of liquidity into the markets. After eight and a half years of running the Quantitative Easing program, the Fed has decided it’s time to reign in some of that liquidity.
Starting in October the Fed was supposed to sell $10 billion of bonds back to the public. Based on data provided by the Fed on its balance sheet, it only dropped by two billion. Time will tell if the Fed was afraid to find out what might happen if they aggressively reduce liquidity or if they are delaying the start of the program. Either way, if the Fed does proceed with selling down their balance sheet, it will quickly drain liquidity from the economy.
Excess liquidity has to find a home and what it usually does it cause asset prices to rise. Looking back over the past eight years it’s easy to see where all this excess liquidity went. It’s as simple as looking at which asset prices rose the most. We can easily see that liquidity found its way into Bitcoin, commercial real estate, stocks and short volatility, where it has created bubbles. As liquidity is drained, the public will initially try to keep those asset prices up by finding liquidity from other sources. A good example of this is the savings rate, which has fallen to the lowest level since 2007. This tells us that the public is willing to reduce how much they are saving to prop up asset prices. Absent of new sources of liquidity, any attempt by the public to keep asset prices up will ultimately fail. Elevated asset prices will eventually succumb to a fall in liquidity.
Today the Hoover Dam provides stable irrigation for those down river, power for over a million homes and is host to millions of visitors from all over the world. It does the job it was designed to do remarkably well. The Fed, however, has a terrible track record. Despite its best efforts, the Fed has displayed an inability to manage the money supply, which is evident by the recurring boom and bust cycles that occur from the Fed overprinting and the subsequent drain in liquidity. While this recent economic and market cycle has gone longer than I expected, there is little doubt in my mind that the Fed’s decision to drain liquidity from the economy will lead to a severe and elongated recession.
Video Topic of the Week – Black Friday!
If you want to know if the reflation trade is real or if the public is broke, watch the sales numbers from Black Friday. Retailers are loaded with inventory at the same time the consumer is loaded with debt, which could lead to weak sales. If sales are weak, it will be a problem for this overvalued stock market.
Chart of the Week – Throwing Caution to the Wind
This week we’ll talk a look at what happens when Consumer Confidence and the Savings Rate diverge. The last two times this happened was just before the dot-com bust of the 2000’s and before the Great Financial Crisis of 2008.
Portfolio Shield™ Update
No update this week. I’m working on fine tuning the algorithm as I believe there may be room for a slight improvement.
Weekly Broad Market / Economy Commentary
Long-time readers may recall that about six months ago I signed up to receive research from a company that provides data based on momentum. Unlike Portfolio Shield™, which is a price based momentum strategy, this firm’s research was based on momentum from a rate of change perspective. I thought it was interesting, so I signed on. I initially tried to replicate their research, but I failed. Yesterday I figured it out and believe I can replicate their momentum research.
What I find interesting about rate of change momentum is that it takes price and charts completely out of the picture. It also tends to find upside breakouts before one would occur on a price chart, which makes this research very interesting.
Many successful investors will tell you they look to trade the middle move in price, which means forgoing the early and late returns. Or for those football fans, these people trade in between the thirty-yard lines. Price momentum strategies, like Portfolio Shield™ can do a good job most of the time, which it does. To the point, I haven’t seen a price momentum strategy as good as Portfolio Shield™.
A rate of change momentum strategy would catch the price breakout before a price momentum strategy would. Now that I have a strong idea of how to replicate change of momentum data, I can build an algorithm and have Morningstar® back test the results.
To which I believe I can create a super strategy that considers a wide range of asset classes where the strategy will identify momentum breakouts in either direction. Upside momentum breakouts would trigger a series of purchase where a downside breakout would push the strategy to cash or to enter a short position. I’ll start work on that this weekend with a test case and I’ll keep you updated. If I am successful, which I believe I will be, it will be a unique strategy that nobody else I am aware of is managing. Exciting!
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