The Fed’s Printing Press is Broken
In the wake of the Great Financial Crisis of 2008-09, the Federal Reserve unleashed a flurry of monetary-policy tools to prevent the global banking system from triggering a global depression. Some of the tools had been used before and some were new, or experimental. In the eight years that followed the Great Financial Crisis, the Fed injected approximately $4 trillion of taxpayer-funded money into the banking system. The public perception of this move was that the Fed was printing money, but as we now know, they didn’t print one dollar. As the current economic cycle slowly comes to an end, the knowledge that the Fed didn’t print any money means the Fed may have inadvertently put our economy in a worse situation now than we faced in 2008-09.
The notion the Fed didn’t print any money may come as a surprise, but the Fed merely created excess bank reserves, as I discussed in my March 30th update. We have evidence that no money was printed during this time; nobody we know directly received one dollar from the Fed. The purpose of those bank reserves was to recapitalize the banks and encourage them to lend. However, only two-thirds of those newly created excess reserves have been lent out. This is because the Fed is paying interest on those reserves to minimize how much of them the banks lend out.
Americans are currently paying the major banks, with our tax dollars, not to lend all their excess reserves. The Fed pays interest on excess reserves in the form of the Federal Funds rate. As the Federal Funds rate increases, taxpayers are paying the banks an increasing amount of interest to not lend against those reserves. The Fed did this to keep inflation in check due to the amount of money the Fed shoved into the banks to keep them solvent. If any of this seems illogical, it is.
Today the Fed is unwinding their $4+ trillion balance sheet, but what they are really doing is removing those excess reserves from the banking system. While this will save the taxpayers money, it will also lead to lower asset prices. Rather than reset the monetary system as the Fed should have done after the Great Financial Crisis, they opted to put a bandage on it instead. And we all know what happens when it’s time to pull the bandage off — it hurts.
With the understanding the Fed can’t directly print money, they attempted to create a wealth effect similar to what our economy experienced in the mid- to late-1990’s. Former Fed Chairman Ben Bernanke determined that if a person feels wealthier, then they will spend more. Turns out this is true. The Fed increased the value of asset prices by increasing the amount of excess reserves in the banking system. As the monetary base increases, so do asset prices. That is how we know asset prices will decrease as the Fed reduces the monetary base.
At the same time the Fed was pumping the banks full of money, they also lowered the Federal Funds rate to zero under their Zero Interest Rate Policy, or ZIRP. This was an intentional move to force long-term interest rates higher. The reason the Fed wanted long-term interest rates to rise was to create the illusion of inflation. This is important to understand because the Fed has no direct control over long-term interest rates, as detailed in a paper written by Daniel L. Thornton, a St. Louis Fed’s staff economist, in the early 2000’s titled, “Greenspan’s Conundrum and the Fed’s Ability to Affect Long-Term Yields.” When long-term yields rise, consumers usually respond by making purchases today due to the fear of higher future borrowing costs.
The Fed’s plan was to create the appearance of inflation by threatening to raise the Federal Funds rate to thus encourage consumers to borrow money. Since our money supply is debt based, as consumers borrow more money, the monetary base expands which causes the economy to grow. As the economy and asset prices grow, consumers end up refinancing those old, bad loans and the problem is washed away by inflation. At face value, this seems like a good plan. Unfortunately, it didn’t work.
We know it didn’t work because the economy has experienced the weakest growth of any expansion in the history of our great country. More evidence that the Fed didn’t print any money lies within interest rates. Interest rates fell following the Great Financial Crisis and didn’t bottom until early 2016. The general belief is that low-interest rates are stimulative, but that isn’t true. Famed economist Milton Friedman’s interest-rate fallacy states that low long-term interest rates are a sign of tight money, while high-interest rates are a sign of loose money.
For those old enough to remember, interest rates in the 1970’s and early 1980’s were high. This was a period where there was too much money, which was evident by double-digit interest rates. Based on Friedman’s research, we know the past eight years have been a period of tight money, despite nearly $4 trillion dollars of newly minted excess bank reserves, because long-term interest rates have been relatively low.
Following the election of Donald Trump as our 45th President, interest rates rose in anticipation of his pro-growth spending plans. It is important to understand that interest rates rose after the election due to speculators betting on higher interest rates and the public selling their bonds to buy stocks, not because of the Fed. In other words, market participants created the illusion of higher interest rates. Historically higher interest rates have been an indication of a loose money supply, which has led the Fed to begin tightening the monetary base.
The evidence that money is tight is visible in 10-year Treasury yields. In the last economic cycle, 10-year Treasury yields peaked around 5.2%, while in our current cycle yields peaked at 3.95%. Assuming Friedman’s interest rate fallacy is correct, money is tighter today than it was leading to the Great Financial Crisis. To make matters worse, we have more debt and lower wage growth then we had going into the Great Financial Crisis.
The Fed isn’t helping matters either. By raising the Federal Funds rate and reducing their balance sheet, the Fed is deliberately decelerating the growth rate in the money supply which is having the effect of tightening the money supply. According to Friedman’s interest rate fallacy theory, a tighter money supply means that interest rates should fall.
The risk of a tighter money supply is that our economy will fall into a recession. Based on the growth rate in the money supply, risks of a recession are increasing. This past week the growth rate of the money supply slid to 3.73%, which is one rounding error away from sounding recessionary alarms. In the past, when the growth rate of the money supply fell below 3.7%, there was an 80% chance of our economy falling into a recession, or even worse, depression.
If you think the actions of the Fed don’t make sense, it’s because they don’t. The Fed is engaged in draining the money supply, or lifeblood of our economy, at a time when most investors have all their money tied to risk assets. While I can’t tell you what the Fed is hoping to accomplish, I can tell you the growth rate of the money supply is telling us that a recession or worse, a depression, is on the horizon. And the scary part is the realization that the Fed may not be able to “print” our way out of the next crisis.
Special Update – S&P 500 Annual Momentum
As you may be aware I’ve been working on a follow up to the Portfolio Shield strategy using annual momentum. Annual momentum looks at the year-over-year rate of change in a security. When the rate of change is positive, the algorithm recommends buying. When the rate of change turns negative, it recommends moving to cash.
The reason this concept works is when major indices, such as the S&P 500, have a negative year-over-year change in price, the probabilities of a Bear market increase exponentially. And as we all know, it’s not how much money we make that matters, it’s how much we lose that has an impact. A 1,000% gain can be wiped out by a 100% loss. The special part of the algorithm is its ability to find market bottoms with a greater than average probability.
Over the past month or so I’ve been sharing with you what momentum looks like in the chart part of your weekly update. One of the challenges I ran into when building the algorithm was that on a daily basis it would have too many buys and sells, so I tested a weekly and monthly algorithm to see what it would look like.
The weekly algorithm did a nice job of smoothing out the data and it worked! I’ve attached a Morningstar® Investment Detail report showing the S&P 500 Index (SPX) vs the SPDR S&P 500 ETF (SPY) with my annual momentum algorithm applied.
The results are impressive. This strategy is not ready to be implemented but this is the first piece in putting together a bigger strategy using momentum data. The next step will be to run the algorithm through the Nasdaq-100 and the Russell 2000 to see how it would compare to the existing Portfolio Shield™ strategy.
Portfolio Shield™ uses a bond fund to hedge market downturns, whereas momentum goes to cash. Now that I’ve worked out the weighting formula, it’s just a matter of running the data on the Nasdaq-100 and the Russell 2000, and then combining them as I do with Portfolio Shield™ to see how the two compare.
Rather than share with you the details, I thought I’d let the report speak for itself. It is linked below in the box titled “S&P 500 Annual Momentum Prototype.”
Q&A with Steve – Your Questions Answered
- Why are markets so volatile lately?
Back in February, the short-volatility structure was broken and the Fed is unwinding their balance sheet. Both have increased volatility. When volatility rises, stock prices can rapidly rise or fall. While there are periods of heightened volatility where stock prices are rising, rising volatility is usually bad for stock prices.
Expect volatility to continue rising.
- On Tuesday and Wednesday, the S&P 500 held its 200-DMA. Is that a bullish indicator?
Technical analysts would say a hold of the 200-Day Moving Average is a bullish indicator. What few understand is that there are more programmed trades that would start selling if the major indices fall below their 200-DMA. I believe the “smart money” defended that moving average in hopes that retail investors interpret as a buy signal.
Based on recent research, if the S&P 500 closes around 2,550, it should trigger a large amount of programmed selling.
- Markets surged on Wednesday. Is that a sign the Bull market is back?
I don’t believe so. Trading volumes on Wednesday and Thursday were low, with Thursday’s trading volume considerably lower. When lots of people are buying, trading volume rises, which is an indication of strong demand.
When prices rise on low volume its an indication that the sellers are absent.
The way I have interpreted this week’s market action is that the sellers are trying to lure buyers back in so the sellers can sell. A rapidly rising market off of a major trendline (the 200-Day Moving Average) is a signal of bullishness to the public, so they tend to buy. But when prices rapidly rise on low volume, it means that those who are buying are paying a steep price.
I have a hunch the sellers will return.
- Why do you think the “smart money” is selling?
The Fed is draining liquidity and markets move mostly on liquidity. As liquidity falls, so do stock prices. The “smart money” wants out, but they need willing buyers to sell to. With most major indices negative for the year, the “smart money” needs to make it appear to the retail investors that this is a buying opportunity.
- What is the general attitude of the markets?
- Will they be wrong?
Yes – falling liquidity means stock prices will continue to fall. Most investors do not understand or believe liquidity drives stock prices.
- Fundamentals, such as earnings are why stock prices are higher!
If you believe that, and many people do, then the S&P 500 would have peaked around 1,800, not 2,800.
- How are Hedge Funds invested?
Most Hedge Funds are positioned for a massive reflation trade. They are short the U.S. dollar, record long oil, record short 10-year Treasuries and long stocks. If inflation doesn’t come, there will be a mass unwinding of those positions which will drive the stock market down.
- Isn’t inflation coming?
I don’t believe so. There are factors that are leading to higher prices, such as higher minimum wage laws, higher short and long-term interest rates, and higher insurance costs. I believe most of the inflation we are seeing is due to the multiple natural disasters last year which led to an increase in the velocity of money.
I need to dedicate the next couple updates to explaining inflation and the velocity of money.
- Aren’t wages going to rise soon?
Rising wages without an increase in the money supply will be rejected. Given the growth rate of the money supply is decelerating, any growth in wages will eventually be rejected.
- Why is the Whitehouse pursuing tariffs?
I have no idea. Given we export inflation in the form of dollars which are used to purchase our debt, a large trade deficit is to our advantage.
- The jobs report didn’t seem that good. What’s your take?
There is about a four-month lag between when a company decides to hire and when an employee is added to the payrolls. The decision to hire in November 2017 didn’t show up until the February 2018 payrolls. The March 2018 data goes back to December 2017, where we saw retail sales contract.
Retail sales contracted in December, January, and February, so it is unlikely that employers will need to hire until they see sales rise. Based on that, I expect weak payroll growth for the months to come.
- But weren’t the tax cuts supposed to spur growth?
Yes, but when the public senses something is temporary, like the tax cuts, they get saved rather than spent. For the past two months, we have seen the savings rate increase at the same pace of the tax cuts.
- What were the payroll numbers?
The headline number for March was +103k, which fell short of analyst expectations of +185k. Job gains from January and February were revised down a total of -50k combined, meaning the net job growth for March was +53k.
Hours worked are growing at a rate of 2%, which is down from last quarter’s rate of +3%. Wage growth held at +0.3%, but the data shows most of that went to the managers and supervisors. Wage growth for everyone else fell.
- Are you concerned that tariffs will impact crop prices?
Normally tariffs lead to higher prices. Argentina’s soybean crop has been devasted by drought, so if China reduces their purchases of our soybeans, that will lead to higher soybean prices. Lower global supply and high demand should spur prices higher.
- What drove the markets down on Friday?
Jerome Powell said the Fed will continue draining liquidity from the economy. Wall Street understands that liquidity drives markets. The public doesn’t, so Wall Street sells on news the Fed is not going to support the equity markets.
Video Topic of the Week – Momentum and Jobs
A brief mention of the backtested momentum data and my thought on this week’s jobs report.
Chart of the Week – S&P 500 vs Bitcoin
Does the market follow Bitcoin’s price? You might be surprised to find out!
Portfolio Shield™ Update
The strategy maintains its equity allocation for April. The April Morningstar® Investment Detail Report should be available next week. Just waiting on Morningstar® to finalize some of their data.