Printing Our Way to Prosperity
The Federal Reserve was able to print its way out of the tech and mortgage bubbles which has given investors confidence that the Fed will be able to print its way out of our next crisis. Rather than protect themselves against the next recession, investors are betting their life savings that the Fed will be able to use its “printing press” to keep the stock market from crashing again.
The evidence in favor of the Fed is compelling – they minimized the effects of the 2000-02 recession, the 2008-09 recession, the initial fallout from the Brexit vote and the early 2016 stock market correction. Investors are finding comfort taking risks with their life savings with the belief that the Fed can quickly react the next time there is a problem.
While the public perception is that the Fed can print money to solve financial problems, the Fed doesn’t have the ability to print money. Knowing the Fed can’t print its way out of problems means that the Fed may be unable to bail out the stock market during the next recession.
To understand what powers the Fed does have, we must go back to the Great Financial Crisis of 2008-09. As liquidity dried up and asset prices began to plummet, the Fed came to the rescue by implementing various programs to increase the monetary base. The public saw this as a money-printing scheme, but all the Fed did was recapitalize banks. The Fed didn’t print any money, but it certainly appeared that way. In a debt-based, monetary system, money can only be created when there is an increase in lending, as is the case with the Fed.
The proof that the Fed can’t actually create money is that you, nor I or anyone else, directly received one penny of the nearly $4 trillion the Fed created to recapitalize the banks. The money the Fed created went into what is referred to as “excess reserves.” Banks have a minimum amount of reserves, or money, that they must hold as required by the Federal Reserve to manage their daily operations. Any amount over the reserve requirement is referred to as “excess reserves.” While the amount of money in excess is added to the monetary base (the monetary base counts the money in circulation and the money in excess reserves), it doesn’t enter the economy or money supply until the banks lend it out.
In the wake of the Great Financial Crisis, financial conditions remained tight and our country almost entered a second recession. To alleviate the problem, the Fed lowered the Federal Funds rate (to lower short-term interest rates) and pumped more money into the banks’ excess reserves. Eventually, the banks started lending and the money supply expanded. It is critical to understand that had the banks not lent out any of that money, the Fed’s efforts to inject liquidity into the markets would have failed.
To keep the banks from rapidly lending against these newly created excess reserves, which would be highly inflationary, the Fed decided for the first time since the early 1930’s to pay interest on excess reserves. The Fed was able to recapitalize the banks but, by paying interest on excess reserves, they were able to keep inflation under control. The Fed decided to pay interest on excess reserves as an incentive to minimize lending against those newly created excess reserves. As the unemployment rate falls, the Fed fears that those excess reserves could lead to very high rates of inflation.
The reason the Fed is unwinding its $4+ trillion balance sheet is specifically to reduce excess reserves. The Fed fears that with a low unemployment rate and the recent tax cuts, consumers will want to borrow large amounts of money. While the Fed doesn’t have a problem with people wanting to borrow money, they do fear that if too much money is borrowed too quickly, it will lead to hyperinflation. The reason excess reserves can create inflation is because banks can lend out 10 times against their excess reserves.
According to the Minneapolis Fed, $2.4 trillion in excess reserves could be lent out to create $24 trillion in new loans, which would cause the M2 money supply to triple. Now you can see why that as the unemployment rate falls, the Fed is suddenly concerned about inflation, even though consumer price inflation remains below the Fed’s 2% target. The fear is that a sudden demand for loans could spike the money supply faster than the Fed can react. To counteract that fear, the Fed is draining excess reserves by raising the Federal Funds rate and by selling off its $4+ trillion balance sheet. Both actions reduce the number of excess reserves, which will reduce the monetary base and should lead to the reduction in the growth rate of the money supply.
When the next recession comes, the Fed will undoubtedly attempt to alleviate the symptoms to stabilize the economy. The notion that the Fed can print money isn’t true. The Fed can choose to monetize government debt, but monetizing debt isn’t the same as printing money out of thin air. Any monetized debt would be in the hands of the Federal government to spend as they see fit. The government could spend that money to stimulate the economy, but as we know, when a nation’s debt level reaches a certain level, the stimulative effects of monetizing debt greatly falls. In other words, the government would have to spend big and the Fed would have to be willing to monetize that spending for the economy to benefit.
During the next recession, the Fed will likely need to recapitalize the banks by flooding the banks with excess reserves and lowering interest rates, just as the Fed has done in the past. As we now know, unless the banks lend against those excess reserves, there won’t be any growth in the economy or money supply. This means it is possible that during the next recession, the Fed’s efforts to reflate the economy may fail.
We have 50 million Boomers that are in, or are approaching, retirement and as a group have invested nearly 100% of their retirement savings in risk assets under the belief that the Fed can print money to prop up stock prices. As we now know, the Fed can supply liquidity to the banking system, but they can’t print money and they certainly can’t prevent stock prices from falling. Instead, the public should fear what may happen to the value of their risk assets if the Fed is unable to save the global economy from the next recession.
Q&A with Steve – Your Questions Answered
- What caused the market sell-off on Monday?
There wasn’t any specific catalyst, although Facebook was likely to blame. After nearly 18 months of the market rising on Fed liquidity, as the Fed drains liquidity, the market will fall.
- Did the Fed raise rates this month?
As I expected, the Fed raised rate 0.25%. The Fed anticipates raising rates two more times this year and three times next year, assuming the economy doesn’t recess.
- Were there any changes to the balance sheet runoff?
No, Powell says the Fed plans to continue selling off their bond portfolio as planned. The Fed is currently selling $20 billion per month which will increase to $30 billion in April.
- What is the effect of the balance sheet runoff?
As we learned from Dr. Lacy Hunt’s presentation at the 2018 Strategic Investment Conference, every $60 billion in bonds sold is equivalent to a 0.25% hike in the Federal Funds rate.
Currently, the “effective” Federal Funds rate is 3.00% when factoring the balance sheet runoff. Assuming no further hikes in the Federal Funds rate, its effective rate will be 4.50% based on the planned balance sheet runoff.
- Won’t this cause interest rates to rise?
Yes, as the Fed raises the Federal Funds rate, short-term interest rates will rise. Back in the mid-1980’s, the correlation between the Federal Funds rate and long-term interest rates ceased to exist.
Speculators have been driving long-term interest rates higher, but lending demand is falling. For long-term rates to continue rising, bondholders will need to sell. Most investors have sold their bonds, but most bond buyers tend to hold their bonds to maturity. For long-term yields to continue rising, pension funds, institutional money managers, and sovereign wealth funds would need to sell.
To put this in perspective, state and local pension funds on average are holding a 70% allocation to equities and a 30% allocation to bonds. It is unlikely pension funds will dump their remaining bonds to increase their equity allocation to 100%.
- Do these rate hikes really matter?
Yes! Since World War II there has been thirteen rate hike cycles. Ten have led to a recession and three a soft landing. In the soft landings, GDP growth was reduced by two percent. If that were to happen now, GDP growth would be near zero or slightly negative. Odds are high that we won’t see a soft landing.
- Will interest rates continue rising during the next recession?
While its possible they will, yields usually fall approximately 1.6% during recessions. If that were to happen today, yields would likely fall back to their prior all-time low.
- What triggered Thursday’s market selloff?
Nothing – The Fed is reducing its balance sheet and tightening the money supply. When that happens, asset prices fall. This or any future drops in the stock market shouldn’t come as a surprise.
Video Topic of the Week – The Markets Make the News
Markets make the news, not the other way around. Did the news of tariffs trigger Thursday’s sell off? Tune in this week to hear my thoughts.
Chart of the Week – S&P 500
The S&P 500 broke its upward annual momentum trendline a few days ago. The last time it broke a rising trendline, there was a market correction early in 2016. The prior two times it broke its rising trendline, we had recessions.
Portfolio Shield™ Update
At the rate stocks are selling off, it’s entirely possible that this strategy will add bonds to the allocation next month to reduce downside risk.
Work progresses on the new strategy, but due to time constraints, I am manually updating and reviewing the momentum data for 30-40 funds daily. I have created a watch list of potential sectors that we could start investing in as their momentum turns positive. Even though the stock market may start falling, there are always some sectors that rise. I want to catch those sectors as early as possible. Fortunately, momentum gives me an idea of which they are. One of the challenges I’ve run into is that price needs to match the direction of momentum, so I will need to come up with a way for price to validate momentum.
Utilities – Momentum is negative and starting to slow. Utilities are a defensive sector, which has generated limited upside return going into major market meltdowns. There may be a short-term opportunity here if momentum turns higher. If momentum continues to fall, this sector could be an early indicator of a larger market drop.
Gold and Silver Miners – Momentum is negative, but the rate of its fall is rapidly slowing. I expect in the next week or two that momentum and price will turn positive, which will validate our entry point.
The miners should follow a breakout in gold, which could happen as early as $1,350/oz.
Real Estate Investment Trusts (REITs) – The setup with REITs is the same as the Utilities sector. Potential short-term opportunity.
Telecommunications – This sector is also showing a similar setup to Utilities and REITs.
Treasury Bonds – Momentum is about to validate a lower high, even though price is showing a lower low. Price is starting to rise, and momentum should follow. Historically rising prices with a higher low in momentum has flagged a huge rise in bond prices.
Treasury Inflation Protected Bonds (TIPs) – TIPs are a proxy for gold. Price is rising, but momentum is falling. I expect momentum to rise. I may use these as part of the allocation in the two lower risk portfolios.
U.S. Dollar – While I don’t have any plans to invest in this sector, its direction can affect that of many other sectors. The general belief is that the dollar is headed on a major downward spiral. Price has started a bottoming pattern and my composite momentum algorithm has started a slight upward turn. Annual momentum remains negative, but it too is starting to turn upward. While I believe the dollar should rise, if it does, it will catch many investors off guard.
On a side note, I had the opportunity to review annual momentum data from the person who I learned momentum from. He flagged the dollar downturn in May of last year. My research flags the exact same month. He said he doesn’t know if the dollar will continue to fall, whereas my data indicates it may be bottoming now. I think that’s cool!
Agricultural Commodities – Despite a recent drop in price after two months of prices steadily rising, momentum remains positive. At some point price will catch up with momentum and this sector will take off.