Can the Economy Boom with the Fed Raising Interest Rates?
In 2016, the Federal Reserve began hiking the Federal Funds rate, or the bank-overnight rate. In October 2017, the Federal Reserve began unwinding their balance sheet. Both actions are causing short-term interest rates to rise. The Fed chose a gradual path of increased rates to allow the economy to adjust to their plan to tighten monetary policy. Stock market participants welcomed higher interest rates by continuing to buy stocks, all based on belief in President Trump’s reflationary agenda. For the moment, few believe higher interest rates will have a significant impact on the economy, yet history shows that every time the Fed begins going down a path of tighter monetary policy, the economy eventually recesses.
The risk in the Fed’s plan isn’t the gradual increase in the Federal Funds rate, it’s the unwinding of their $4+ trillion balance sheet of U.S. Treasuries and Mortgage-Backed Securities. Few investors believe that the stock market is highly correlated to the Fed’s balance sheet, but the intended purpose of increasing the size of their balance sheet was to create a wealth effect by raising asset prices, including stocks. The Fed is the first central bank in history to engage in an unwinding of their balance sheet, which should have the opposite effect on asset prices.
Every time the Fed raises the Federal Funds rate by 0.25% it drains the monetary base by $68 billion. The same formula can be used to determine what the effects will be on short-term interest rates as the Fed sells off its bond holdings. For approximately every $60 billion the Fed sells, it has the effect of raising the Federal Funds rate by 0.25%. At the end of March, the Federal Funds rate was 1.625% and the Fed had sold $90 billion of bonds. $90 billion in bonds is equivalent to a 0.38% hike in the Federal Funds rate. At the end of March, the effective Federal Funds rate was 2.00% (1.625% + 0.38%). Assuming the Fed doesn’t hike rates again this year (they currently anticipate two to three more) the effective Federal Funds rate will be 2.38% at the end of June, 2.88% at the end of September, and 3.50% by the end of the year. If the Fed does hike, then those numbers will increase by 0.25% each time the Fed raises the Federal Funds rate.
It’s possible higher interest rates won’t break the economy, but the odds of that are low. When central banks suppress interest rates below their natural level, it leads to a redirection of money from wealth-generating activities to non-productive wealth-generating activities. As interest rates rise, money is pulled from non-wealth generating activities which eventually leads to their collapse. It is the collapse of these non-wealth generators, or malinvestments, that causes recessions. The length of a recession is directly correlated to the amount of real savings. When the rate of consumer savings is low and there is an economic downturn, the longer the economic slump will be.
Economic growth begins with a growing supply of savings. Savings are used to manufacture or purchase capital goods that will hopefully be sold for a profit. This is an example of a wealth-generating activity. When a central bank “prints” money, it takes away the need to save and directs that money to non-wealth generating activities. A good example of a non-wealth generating activity is cryptocurrencies.
Cryptocurrencies are believed to be money and have been used as money, but it is too early to say they are money. The big problem with cryptocurrencies is they are not backed by any physical asset. Cryptocurrencies are backed by the buyers and sellers, and as long as there are more buyers, cryptocurrencies will appear to have value. In 2017, due to a limited supply of cryptocurrencies, prices rapidly rose, but that quickly changed in 2018. Due to the rapid rise in price, potential cryptocurrency investors took money from their savings to buy these “coins,” which redirected money that could have been used to support wealth-generating activities. As cryptocurrencies lose value, so will those redirected savings.
The reason non-wealth generating activities come into existence is due to excessive central bank money printing. Every time there is an economic downturn, central bankers rush to the printing press to solve the problem. In their eyes, the solution to every problem is more money. The evidence the Fed uses to justify printing money is it does create economic growth, which can be observed in economic indicators such as the Gross Domestic Product (GDP). While monetary expansion does lead to an increase in GDP growth, it doesn’t create sustainable, real economic growth.
Prior to the dot-com bubble, Fed Chairman Alan Greenspan lowered interest rates to expand the monetary base in hopes it would keep the economy firing on all cylinders. Low-interest rates fueled the tech bubble which created numerous companies with high valuations, but little or no profits.
As Greenspan raised rates, the tech bubble burst which caused the malinvestment to purge itself from the economy. The malinvestment became obvious when the tech-heavy Nasdaq-100 index fell 80%, leaving only the profitable tech companies in business.
In the aftermath of the dot-com bubble, Fed Chairman Alan Greenspan lowered interest rates to expand the monetary base in hopes it would pull the economy out of a recession. By lowering interest rates, along with the Federal government subsidizing the housing market, Greenspan was successful in reigniting the economy.
Unfortunately, by holding interest rates too low for too long, all Greenspan accomplished was creating malinvestment in the housing industry. As Greenspan raised rates, the mortgage bubble burst which then caused the malinvestment to purge itself from the economy. Along with the stock market, housing prices plummeted 40% to clear out some of the malinvestment.
Fortunately, Fed Chair Ben Bernanke was at the helm during the housing meltdown and in addition to lowering interest rates, he implemented a massive money printing program called Quantitative Easing. Fed Chair Janet Yellen would continue Bernanke’s money-printing schemes, but she took it to another level. The Fed began intervening every time the stock market started to fall. Yellen, as were her predecessors, was keenly interested in doing everything possible to prop up the economy.
Most economists might say that a recession is caused by an increase in unemployment, an increase in consumer prices, a decrease in wages, a decrease in corporate profits, or too much debt. What causes those economic indicators to move in an unfavorable direction is decrease or contraction in the growth rate of the money supply by central banks. As the growth rate of the money supply contracts, money is first diverted from unprofitable activities and later from marginal activities. As money is diverted away from unprofitable activities, bank lending begins to contract, which accelerates the contraction in the growth rate of the money supply and deepens the economic slump.
It is ultimately the liquidations of unprofitable activities that causes recessions. The greater the number of unprofitable activities, the deeper the recession will be. In the past, when economic cycles were approximately four years in length, recessions would only last about six months. The shorter cycles limited the amount of malinvestment, which in turn limited the economic effects of the downturn. Over the past several decades, central bankers have been trying to eliminate economic downturns by extending the economic cycle. As the economic cycles are extended, so too is the amount of malinvestment. When the time comes for the malinvestment to liquidate, there aren’t sufficient wealth-generating activities available to absorb the pool of unemployed.
Can the economy boom with the Fed raising interest rates? It depends on the amount of debt, malinvestment and real savings. If the savings rate is rising and debt levels are falling, then it is possible for the Fed to raise rates without causing a severe recession. If the savings rate is falling and debt levels are rising, as they are today, then it is impossible for the economy to grow as the Fed raises rates. In future updates I plan to dig deeper into the savings rate and why it matters to further our understanding of how monetary tightening triggers recessions.
What is important to understand is the next recession will be deeper and longer than the last two, simply due to the high amount of malinvestment that exists in the domestic and global economy from central bankers easy-money policies.
Legacy Portfolio Update
Annual momentum on both Gold and Silver miners started turning this week. The junior gold and silver miners saw their annual momentum turn positive late last week. The U.S. dollar saw its annual momentum turn positive about two weeks ago, but its price has been flat. Based on my backtests, it is prudent to wait about five trading days to confirm the trend before beginning to buy in. I plan to buy in stages rather than go “all in,” just in case there is a rapid reversal.
As other opportunities arise, they may be added to the mix. I am looking forward to putting some of the available cash to work.
Annual Momentum Update
I have two reports this week, which I’m quite excited about. I’m considering a more detailed write up next week. Most of the reports I’ve shared with you are based on buying or selling a specific security based on its annual momentum trend. When annual momentum turns negative, the strategy sells to cash and then it waits until momentum turns positive before buying back in.
The two investment detail reports this week show a move to long-term Treasuries when annual momentum breaks its trendline instead of cash. The results are impressive. I hope you’ll take a few minutes to download them and look at the historical performance.
I am contemplating making this the basis of the new strategy, because I’m not sure I can make it any better, nor am I sure it needs any more moving parts.
Until I can provide a more detailed explanation, I hope you enjoy the reports, because this is the future of where we are going.
Q&A with Steve – Your Questions Answered
- What happened to the stock market on Monday?
Markets opened higher, but with a muted response from the Syria bombings. The major indices chased down their overhead 50-day moving averages but failed to close over them. Trading volumes remain very low, which is an indicator the “smart money” isn’t buying and that liquidity is being drained.
Trading volume is an indication of buying strength or selling weakness. When volume falls in a rising market, it’s an indication that buyers are tapped out. Unless there’s something holding the buyers back, I suspect the sellers will take over soon to drive stock prices down.
- What happened to the stock market on Tuesday?
After failing to close over their 50-day moving averages, which is normally a bearish signal, the major indices opened higher and traded above their 100-day moving averages where they closed. Oddly volumes right up until close were extremely low, again suggested the lack of buying interest. I believe High-Frequency Traders are attempting to prop up the market to entice buyers in. Normally repeated low volume days would bring in sellers, but the smart money seems to be content selling during the last 15 minutes of trading.
Unlike stocks, after repeatedly failing to break back over its 50-day moving average, 10-year Treasury yields fell. With short-term interest rates holding and long-term rates starting to fall, we could be on the cusp of an inverted yield curve which is when short-term yields are higher than long-term yields. An inverted yield curve is significant as it usually signals a recession is coming soon.
- What happened to the stock market on Wednesday?
Wednesday was another lackluster day in terms of volume. This may have been the lowest volume trading day of the year and if not, it was really close. It’s important to understand that in a Bull market, volume should be increasing with price, not the opposite as we’ve seen. This tells me the recent rally is not built on strength. Then again, this is what liquidity drains look like.
Yields rose across the spectrum as short-term yields are pushing closer to an inverted yield curve. As short-term and long-term yields converge, bank profits get squeezed. There is a very high conviction among market participants that inflation is going to cause interest rates to go higher, but the deceleration of the money supply and the Fed’s ongoing destruction of money disagree with that narrative.
The other possibility is that neither the 10 or 30-year yields broke overhead resistance. From a technical standpoint, when price fails to break an overhead resistance level, prices tend to fall to the prior level of support to see if buyers return. Not surprisingly, Treasury bonds fell and hit their long-term secular tend line. I will be very interested to see if this is a level of support as it has been for the past 2.5 months or if there is further selling pressure. Given bond prices haven’t been able to break this level as speculators are record short, I’m guessing prices will hold.
Agricultural commodities blew past their 50-day moving average and closed just below their 200-day moving average. If prices can clear their 200-DMA, there should be a nice rally forming from the inverted head-and-shoulders pattern.
- What happened to the stock market on Thursday?
The equity market failed to hold its 100-day moving average as the recent rally was built on weak volume. Bull markets are built on rising volumes, not falling volumes. The Nasdaq-100 is showing signs of a head-and-shoulders top, which is a bearish signal.
Treasury yields rose on inflation fears, which due to a decelerating money supply are unfounded. Ten-year Treasury yields have doubled topped and 30-year Treasury yields have tripled topped, which is generally a bearish signal for yields.
Agricultural commodities are close to a “golden cross” which is when its 50-day moving average crosses upward through its 200-day moving average. This is usually a signal for market participants that a Bull market in a security is beginning. The last time this happened, agricultural commodities shot up 10% in a short period.
- What happened to the stock market on Friday?
It was a day of red across the board as nearly every asset class sold off. The smart money continues to sell, and the retail investor continues to buy. With liquidity draining, sellers are the smart ones.
Interest rates rose across the board as short-term yields are back where they were in 2009. Market participants believe inflation is coming and that consumers can handle it. Unless I’m missing something, a decelerating money supply never leads to higher wages. I expect consumers to reject higher prices.
This hasn’t stopped speculators from continuing to short longer-term bonds, which is causing long-term bond yields to rise. Part of this is to avoid an inverted yield curve which is when long-term yields are lower than short-term yields. This is a major recession flag that the market is trying to avoid.
The other issue is there are autonomous trading programs called “CTAs” that are programmed to buy stocks and short bonds. When stocks fall, they increase their bond shorts to buy more stocks. As liquidity drains, this will be a problem for anyone who is short. Shorting has a cost and it requires an increasing number of investors to support the trade. As liquidity drains and asset prices fall, I suspect these short sellers will be forced out.
There is also an increasing number of investors talking about buying bonds because they aren’t seeing an economic boom on the horizon.
The last issue with bonds is the roughly 13 million people who entered the financial services industry after 2009. All these people know is a Fed-supported stock market where equities rise and bonds fall. To them, being short is the proper trade, even though there is no correlation between short-term and long-term bond yields.
My hunch is that the system will either break or the big money players will see a huge opportunity to squeeze out all the bond shorts. Either way, a decelerating money supply will win, and yields will fall.
- Why do the markets rise in the morning and appear to hover on low volume?
Lately, there has been a trend where futures contracts on the major indices are being bid up during overnight or pre-market hours. Specifically, who is doing this is unknown, but many believe it is the autonomous algorithmic trading programs that have been dominating most market trades.
The reason stocks appear to “hover” rather than sell-off is because High-Frequency Traders (these computer programs front run trades to scalp a few pennies off each trade) will put ghost trades on the various exchanges to give the appearance that there are buyers at a given price. As these ghost trades sit on the exchange they keep prices from falling. What you are seeing is a sophisticated means of encouraging investors to buy by making it appear that the market is not going to fall from its current price.
This is not something we’ve ever seen before. The fear that most investors should have is when these computer programs stop propping the market up and begin selling. Since they are creating all the liquidity in the market, when they stop providing it, prices will rapidly fall. I understand this may sound unbelievable, but even former Fed Chair Janet Yellen said this is a huge risk to the markets.
- But the debt doesn’t matter anymore?
People thought debt didn’t matter in 2009, but today global debts are 12% higher than they were at the peak of 2009. Debt doesn’t matter until it does.
Video Topic of the Week – General Market Update
Chart of the Week – Treasury Deposits at Federal Reserve Banks
Speculators and market participants are positioned for an inflationary economic boom. When the Treasury raises funds through normal taxation and borrowing, it has the effect of repositioning dollars in the economy. When that happens, it tends to disrupt growth. This week we’ll look at how several asset classes perform during periods where large amounts of money are being repositioned.