The Fed & Trump: A Battle of Money
The view of today’s economic landscape makes little sense. The Fed is actively decelerating the money supply to fight its perceived fear of an inflationary surge. President Trump is trying to increase the money supply to reignite the economy. And to make matters worse, anti-trade policies from the White House will be inflationary, which will force the Powell-led Fed to further tighten the reigns of monetary policy. If the Fed’s and President’s objectives seem diametrically opposed, it’s because they are. There will be no winners in this battle because our economy is too weak, too overindebted and asset prices are too high to stop the cascading effects of failed monetary policy.
Last Wednesday Jerome Powell, the new Federal Reserve Chairman, hosted his first press conference where he stated the Fed will continue unwinding their $4+ trillion balance sheet. As I wrote in last week’s update, the Fed recapitalized the banking system through three successive Quantitative Easing programs to boost the excess reserves of the largest banks. The Fed was hoping these excess reserves would create a wealth effect by boosting asset prices, but it didn’t work. Unlike the late 1990’s, where many people owned stocks and benefited from the wealth effect, today, only half of American’s own stocks.
As I predicted, the unwinding of the Fed’s balance sheet would cause stock prices to fall, even though it seems as if most investors believe that stock prices will rise indefinitely. It’s important to understand that stock prices cannot rise if the Fed is unwinding their balance sheet! While stock prices can rise due to increased earnings and profits, they are highly correlated to the size of the banking system’s excess reserves. After eight years of central bank intervention in the stock market, investors have become accustomed to the Fed bailing out every drop in the stock market. As long as the Fed is reducing the size of their balance sheet, stock prices will continue to fall until they reach fair value or the Fed stops unwinding.
In addition to unwinding their balance sheet, the Fed is also raising the Federal Funds rate. The purpose of raising the Federal Funds rate is to reduce bank lending and to reduce the Velocity of Money (or how often money exchanges hands in a year). Banks create money when a new loan is funded, so to restrain bank lending, the Fed raises interest rates. As interest rates rise, consumers will put their money where they feel they have the greatest opportunity for return. If interest rates are high enough, consumers will put their money in banks rather than invest it into the economy, which will reduce the Velocity of Money and inflation.
The Fed’s objectives are clear: After eight years of easy money policies, they are afraid that inflation will spiral out of control now that the unemployment rate has reached a historically low level. Meanwhile, the White House has an entirely different agenda: to reignite a weak economy.
Tax cuts are normally passed during recessions, as Reagan did during his Presidency, to increase the money supply. By increasing the amount of money people have in their paychecks, consumers tend to spend more. Increased consumption generally leads to economic growth. One of the challenges of increasing the money supply is that the government cannot control how the consumer spends it. If the consumer senses that the wealth transfer is temporary, then the consumer tends to use that money to pay down their debt. Given the temporary nature of the tax cuts and the over-indebtedness of our country, it is likely those tax cuts will be put towards paying down debt rather than being invested in the economy.
The hope of the tax cuts and the recently announced tariffs is to spur domestic demand and consumption. While it is too early to tell where consumers will direct their money, early signs suggest that consumers are rejecting higher domestic prices in favor of cheaper foreign goods. The evidence is found in the trade data that shows a widening trade deficit. In other words, American’s are still consuming, but are becoming increasingly sensitive to price increases as inflation-adjusted wages stagnate and debt-servicing costs rise.
Money flowing overseas in the form of a trade deficit has its pros and cons. The United States biggest export is inflation, which comes in the form of U.S. dollars flowing overseas. As our foreign trading partners amass more dollars, they experience inflation from those dollars. To minimize the effects of inflation, they are forced into returning those dollars back to the United States. Foreign governments return those dollars to us by buying U.S. Treasury bonds.
This relationship of exporting dollars and having them returned by buying our debt has allowed the United States to run persistent and large budget-deficits. This relationship exists to our benefit because we can trade a piece of paper, or a U.S. dollar, for a real tangible good or service. It is this relationship that has created the wealth and prosperity for our citizens relative to that of other nations. To keep that relationship going, the United States must supply the world with an increasing amount of dollars.
In the past year, as interest rates have been rising due to Wall Street speculators and the Fed raising short-term interest rates, there has been a growing fear of who will buy our debt. As the last two large Treasury auctions proved, foreign buyers are being forced to buy our debt, much to the surprise of the mainstream financial media. All one had to do is look at the growing trade deficit to know that our foreign trading partners must buy our debt to keep their export-driven economies running smoothly.
It is important to understand that for this relationship to run smoothly, the United States must provide an increasing amount of dollars for global trade. The recent tax cuts create more dollars, which we know are flowing overseas based on the rising trade-deficit data. But the Fed is doing the opposite. By raising the Federal Funds rate and by unwinding their $4+ trillion balance sheet, the Fed is actively removing dollars from the domestic and global economy.
Due to the actions of the Federal Reserve, the growth rate of the money supply is decelerating. Based on the research of Dr. Lacy Hunt of Hoisington Investment Management, seventeen of the last twenty-one decelerations of the money supply have led to recessions. When you start looking at the global economy from the perspective of U.S. dollar flows, it is easy to conclude that the actions of the Fed don’t make much sense. Arguably, one can infer that the actions of the Fed will trigger the next recession at a point when most investors have a historically high allocation to risk assets and are simultaneously headed into retirement. Scary.
Q&A with Steve – Your Questions Answered
- What caused the sharp sell-off last Thursday and Friday?
It was largely what is referred to as a technical sell-off. The broad market fell below its 100-day moving average which spurred a test of its 200-day moving average. Notably, the volume was only slightly above average, indicating there wasn’t heavy selling. This can be interpreted as High-Frequency Traders frontrunning the sellers, which rapidly drove prices down.
- What pushed the markets up on Monday?
Many believe it has to do with easing trade tensions, but I don’t think that’s the case. Investors should be aware that President Trump campaigned on tariffs and we should expect he intends to follow through with them.
The real story is that the retail investor hasn’t been selling. What that tells Wall Street is that the retail public is very bullish on stocks and will continue buying if they believe that stock prices are headed higher. Since the “smart money” has been selling against retail investors buying, it makes sense that the “smart money” will make the markets appear safe to draw retail investors back.
Another factor is the first quarter is coming to an end and many fund managers are heavily invested in technology stocks, so to make sure their numbers (and bonus) looks good, they buy.
- But wasn’t this a double bottom off the 200-day moving average?
It was! But keep in mind, the Fed is hiking rates, the Fed is unwinding the balance sheet, and there have been some huge Treasury auctions this year. All of them are either repositioning dollars or draining the money supply. Asset prices rise on liquidity, which is being drained.
- Why are markets suddenly so volatile?
When the Fed bought one-third of all mortgages in this country, referred to as Mortgage-Backed Securities, those bonds functioned as a volatility suppressant. Now that they are being sold off, volatility has returned.
- How have the Treasury auctions gone?
Much to the surprise of the mainstream financial media, markets have absorbed three very large short-term Treasury auctions this week without causing interest rates to spike.
The last big auction was on Tuesday which comprised of a huge amount of 7-year maturity bonds. Much to the surprise of the financial media, markets digested the offering.
The reason the financial media can’t grasp how markets can choke down all these bonds is because the media doesn’t realize the Fed is draining the excess reserves of the banks. The same excess reserves the Fed forced the banks to take to save the banks from the financial crisis.
- Speaking of interest rates, what’s the status of the bond market?
Speculators are still heavily short 10-year Treasuries but have turned long on 30-year Treasuries. Markets are doing everything they can to convince investors to sell their bonds to buy stocks.
The net effect should be that yields should start to fall.
- If liquidity is being drained, why are people so bullish on stocks?
The mainstream financial media’s job is to sell stocks, not to educate investors on the risks of owning stocks. Plus very few people understand how liquidity drives markets.
- Whatever happened to the Petroyuan?
The Petroyuan went online Sunday evening (PST) and handled 10 billion transactions in the first hour. That amount of volume is impressive! But those exchanges are only open for four hours a day, so they won’t replace the dollar-based exchanges any time soon.
- What are the ramifications for the U.S. dollar?
In the short term, there’s not much risk, but it will put some downward pressure on the dollar. The long-term is an entirely different story.
- When do you plan to invest the cash in the portfolios?
The initial move will be when Treasury yields break their key support levels on the way down. I suspect sometime following, I will rebalance the portfolios to bring in the gold and silver miners, or any other sector the momentum data flags as a potential buy.
- What’s the status of gold?
Gold (physical) is approximately three months from completing a 4.5-year bottoming pattern. In the meantime, it is hovering between $1,350-1,375/oz. – right below the top of the pattern. A break above those levels suggests gold (and the miners) will resume its bull market. A move below means gold would likely fall as I expected it would a few months back.
- What are the Fed’s plans for next month?
Starting I April the Fed will increase its balance sheet unwind from $20 billion per month to $30 billion per month – a 50% increase. Stock market volatility should continue rising and stock prices should continue falling.
- Aren’t fundamentals strong?
I keep hearing how stock prices are justified by fundamentals, but that just isn’t the case. Based on corporate earnings, the S&P 500 should be at 1,800, not 2,800.
- Who cares about earnings if profits are up!
According to the National Income and Product Announcements (NIPA), corporate profits (before tax and inventory valuation, and capital consumption adjustments), are below their 2014 peak.
Stock prices have front run profits – not a good sign when the consumer is retrenching.
- How far do Treasury yields fall during recessions?
On average about 1.6%, which would take the 10-year Treasury yield down to about 1% — if a recession started today. I believe 10-year Treasury yields will get close to 0% by the time this is all done.
Keep in mind that interest rates peak ahead of recessions!
- All this debt doesn’t really matter anymore, does it?
In 2007 the debt-to-GDP ratio stood at 225%. As we all know, it turned out to be a problem. Today the debt-to-GDP ratio is at 250% and everyone is piled into risk assets. Why things will be different this time is beyond me.
- If interest rates fall, does that open opportunities?
Yes! In the daily report I get from one of the top economists in North America, he said to watch the Utilities, Telecommunications and Real Estate sectors. All of which my new momentum algorithm has targeted for possible upside potential!
- What’s the latest on the momentum strategy?
I’m still updated and tracking the data daily. I found glitch in the weighting formula that I haven’t been able to isolate. Normally I pull that data directly from Morningstar®, but accessing their system isn’t as easy as directly running the formula. I’ve engaged my service team to see where the discrepancy is. This isn’t a problem with implementing the model as much as it is back testing the model.
I’m looking at doing a weekly momentum formula instead of a daily formula. The data on a daily basis is very noisy and the more I smooth the data out, the less accurate it is. I’m going to run a test on the weekly data. So far the system appears to be identifying opportunities, which is exactly what I want it to do.
I’m hoping with the long weekend that I will have more time to think through how it works and test some ideas.
Video Topic of the Week
The video will be limited to the charts due to Good Friday.
Chart of the Week – The Smart Money
Is the smart money buying or selling? Tune in this week to find out!
Portfolio Shield™ Update
The next rebalance is scheduled for Monday. Early expectations are that the strategy will hold its equity allocation.