Weekly Economic Update 07-13-2018

The Fed: Masters of Illusion

I remember as a young boy I saw the up and coming magician David Copperfield at the Bakersfield Convention Center. Watching in amazement, little did I know that Copperfield would become the most commercially successful magician in history. I still remember watching the TV special where Copperfield made the Statue of Liberty disappear. Today I know such illusions are mostly camera tricks, but at the time, his tricks made me believe, for a moment, he had done the impossible. While Copperfield’s illusions are among the best illusions ever performed, I will argue it is the Federal Reserve who is the greatest illusionist of all time.

Over the past two years, I have written extensively about the Federal Reserve’s money-conjuring policies and how they affect the economy. It has come to my attention that the Fed’s policies are confusing and I believe it is worthwhile to try to simplify the Fed’s objectives. If you find the Fed’s policies confusing, you should—it is designed to keep the public confused. The Fed doesn’t want anyone to truly understand what they are doing, rather, they want us to accept they are acting in our best interest, even though they aren’t.

The Great Financial Crisis of 2008-09 nearly triggered a complete collapse of the global financial system. The Fed and other global central banks rushed to “fix” the problem that they created in the first place. The Fed believes the solution to every financial problem is to create more money. However, the Federal Reserve Act of 1937 prohibits the Fed from printing money, so they lure more money into the economy by adjusting short-term interest rates and by adjusting asset prices to change the amount of excess reserves in the banking system.

To fix the financial system from the Great Financial Crisis, the Fed needed to create money without printing it. In other words, the Fed needed to create the illusion of money printing, or inflation, to save the financial system. The proper definition of inflation is a rise in asset prices due to an increase in paper, or fiat currency.

Lacking the tools or ability to print money, the Fed needed to inflate asset prices to create the illusion of printing money. The Fed pumped nearly $4 trillion into banks’ excess reserves through policy tools called Quantitative Easing 1-3 which swapped bank-held U.S. Treasuries and Mortgage-Backed Securities for U.S. dollars.

While it appears the Fed printed money through QE 1-3, they didn’t. Money is not created by the Fed nor the Federal government, but through the banking system when banks make new loans. The Fed raised the amount of excess reserves, nothing more. In a fiat currency system such as ours, whenever the amount of money in the system increases, by any means, asset prices rise.

By increasing excess reserves, the Fed caused financial assets to increase in value. This is why the stock market and real estate values increased as a result of QE 1-3 because the amount of money in the financial system increased. Hopefully, now you can see how the Fed used QE 1-3 to increase asset prices, which looks like inflation (or new money), without actually printing a penny, so to speak.

To sell the lie to the American public, the Fed would have to do more. While Generation X’ers and younger generations don’t remember, Boomer’s do remember the inflation of the late 1970’s and early 1980’s. Ask any Boomer what happens to interest rates during periods of high inflation and they will tell you that both short-term and long-term interest rates rise.

The problem with the Fed’s grand illusion was that both short-term and long-term interest rates were falling. Short-term interest rates were falling because the Fed lowered the Federal Funds rate, or bank overnight-lending rate, to zero. Long-term interest rates were falling because credit conditions were collapsing. To sell the American public on the illusion of inflation, the Fed needed long-term interest rates to rise.

In the second phase of the Fed’s grand illusion, they needed the American public to believe inflation was coming and that long-term interest rates were going to dramatically rise in the future. When the public fears rising inflation or higher consumer prices, they will choose to borrow and spend today before prices rise. The Fed was hoping consumers would increase their borrowing and spending because it would create inflation. After the Great Financial Crisis, most American’s weren’t in a financial position to borrow and spend as much as the Fed needed them to in order to make an impact.

Very few financial professionals understand what causes long-term interest rates to rise and fall. Prior to writing this piece, I watched an interview featuring three well-educated financial professionals who all agreed long-term interest rates should continue to rise, citing an inaccurate research piece that showed long-term interest rates should rise as the Fed unwinds their balance sheet.

Professor Milton Friedman created the best model for interest rates which shows that during periods of monetary accelerations, long-term interest rates should rise and during periods of monetary decelerations (or contractions), long-term interest rates should fall. The Fed needed to make long-term interest rates rise without printing money because monetary accelerations only occur when money is being printed.

The challenge for the Fed is they do not have control of long-term interest rates, so they cannot directly manipulate them higher. Since the banks are the only institutions in our country that can create money, which would cause interest rates to rise, the banking industry would need to massively increase lending to create new money. Banks weren’t lending and consumers weren’t borrowing, so the Fed had to conjure up a way to cause long-term interest rates to rise.

When banks lend they need to hold assets to back the loans. Long-term loans need to be backed by long-term assets. Long-term U.S. Treasuries are the perfect asset for banks because they are considered risk-free and they can be counted as a reserve asset. The Fed modified their Quantitative Easing programs to purchase long-term U.S. Treasuries and Mortgage-Backed Securities, or home loans, both of which are long-term debt instruments.

By removing long-term assets from the banks, long-term interest rates began to rise to attract capital back to the banks. During the latter half of Quantitative Easing 1, and during both Quantitative Easing’s 2-3, long-term interest rates rose. The illusion worked.

Professional money managers worldwide began believing inflation was coming to the United States because both asset prices and long-term interest rates were rising. The only reason short-term interest rates weren’t rising is because the Fed was suppressing short-term interest rates. In response, money managers began advising their clients to sell bonds and short bonds, both of which cause long-term interest rates to further rise.

Phase one and two of the Fed’s grand illusion were working. The Fed was able to create the illusion of inflation without printing money and the public completely bought into the trick. The American public believes that stock prices and real estate prices are only going to go higher and they believe interest rates are going to increase as well. But the greatest illusion of all is yet to come; turning the lie into reality.

The third phase of the Fed’s illusion will be in full-effect when the public believes the illusion is real. If you believe David Copperfield actually made the Statue of Liberty disappear, then he did. While we may not know exactly how he made the Statue of Liberty disappear for TV audiences in 1983, he did. The Fed is trying to handoff the illusion of a booming economy to the public but I believe it won’t work.

Ever since the Federal Reserve was founded in 1913, they have been trying to use their powers to manipulate the U.S. economy into a perpetual state of growth. The Fed has become a master of the first two phases of the illusion but has never successfully made the transition from illusion to reality. In fact, no central bank in history has ever successfully transitioned the lie into reality without crashing their economy.

Next week, in the second part of this piece, I’ll show you why the Fed can never achieve the transition from lie to reality, by walking you through how the Fed hopes to achieve their goal. Once you understand the Fed does not have the tools to make the transition work, you’ll understand how and why the next recession will be the worst in our lifetimes.

Q&A with Steve – Your Questions Answered

  1. What happened to the stock market on Monday?

I look at the trading volume on the largest S&P 500 (symbol: SPY) for an indication of how much trading is going on in the markets. On July 3rd, when the markets closed early, SPY traded just over 42 million shares. Counting after-hours trading, SPY traded 48 million shares during a full day. That’s very low volume.

Sellers have been absent from trading the last few days and are letting the Bulls run up the market. With second-quarter earnings on the horizon, companies should start entering their 5-week blackout period ahead of their earnings announcement in the weeks to come. Companies are prohibited from buying shares back during the 5 weeks leading up to their earnings announcement.

Over the weekend I read a number of articles that indicated the only buyers in this market are corporations buying their shares back. The data is showing that retail investors and hedge-fund managers aren’t doing much trading, which supports today’s ultra-low trading volumes.

Given the bullish outlook over the past few days, it is likely the major indices will push higher and attempt to make new all-time highs this week. Of course, I find this interesting, considering we just engaged in a trade war with China and the Fed is engaged in tightening the money supply. The stock market continues to ignore all forms of risk.

The heatwave isn’t showing any signs of hurting crops yet, but I have previously read the USDA intends to overstate crop conditions this year after several years of understating crop conditions. US farms exported a massive amount of soybeans this last quarter in advance of the soybean tariffs going into effect.

Physical gold tried to rally last night but got hammered down during today’s trading. The gold and silver mining stocks, which tried to front-run the move in the physical metals, also got hammered back down. While the season for gold and silver may be upon us, that day is not today.

The U.S. dollar tagged its 50-day moving average, which is a signal I’ve been looking for. Once I get the all clear on the Treasury bond momentum indicator, I will look to add a small position in the dollar to the portfolios.

  1. What happened to the stock market on Tuesday?

The broad equity market has been range-bound since November. Focusing on the S&P 500, it has been trading between 2,580 and 2,800, with one move up to 2,872. The trading ranges are well established: Bears are selling between 2,750-2,800, while the Bulls are buying between 2,575-2,620 (although the Bulls have been buying at higher points, this is the main trading range). On weak volume, a sign the Bulls are running out of steam, the S&P 500 has moved back up to 2,800. At this point, it’s up to the Bears to defend, or there will likely be a breakout to the upside for equities.

The Bulls have the recent payrolls report data, the tax cut, and the upcoming Q2 earnings report on their side. The Bears have the Fed, the rising dollar, and trade wars on theirs. Liquidity is draining from the markets, and since markets move higher on rising liquidity and lower on falling liquidity, it’s more likely equity markets will run into a wall at the 2,800 level.

The next few days should tell us if there is going to be a big move higher in stocks or a big move lower.

Bond Bears have stepped up their game and taken record bets that interest rates are going higher. Little do these speculators know that the large US banks are back buying Treasuries. The banks are seeing tighter lending conditions while the speculators are seeing inflation. The banks will be right.

  1. What happened to the stock market on Wednesday?

The Producer Price Index (PPI) came out today showing producer prices, or factory prices, are rising. We should assume producers will attempt to pass higher prices onto consumers but how well it will be received is unknown. Given the deceleration of the money supply and the lack of wage growth, it’s logical to assume consumers will reject higher prices. The Consumer Price Index (CPI) comes out tomorrow which will likely show an increase in consumer prices.

Most people perceive higher prices as inflation, but considering the money supply is decelerating, it’s not inflation. Higher prices are coming from higher commodity prices, which are due to higher demand, higher minimum wage laws, higher employee benefit costs and higher interest rates – none of which are inflationary. Remember, inflation is a rise in prices due to an increase in the money supply.

Foreign stock markets were down on average over 1% last night on the news that President Trump is preparing for additional tariffs against China that will go into effect by the end of August unless China changes their trade policy. US equity indices were down but not as much. Corporate share buybacks are holding the equity market up during a period they would most likely be down.

Today’s 10-year Treasury auction showed strong demand from foreign bidders, which honestly is a bit of a surprise. I expected weaker foreign demand in a response to President Trump’s trade war, but it appears foreigners were not deterred. Perhaps foreign investors are seeing weaker global growth and are moving money into safe assets. Treasury yields were down across the board and should be giving us a buy signal within a few days (or less) on my momentum algorithm to bring those with cash into the models.

The US dollar is on the rise, most likely due to a member of the Federal Reserve board stating today that he was going to support further rate hikes. When central banks tighten monetary policy, as the Fed is doing now, it generally leads to a stronger currency. Once cash is brought into the models, I will look to rebalance the other portfolios to add a small US dollar position.

Equity markets started the day down and closed lower on the fears of a full-blown trade war. Trade volumes started the day higher buy by market close, trading volumes were once again well below their long-term average. Low trading volume continues to support the view that the only remaining buyers of US equities are corporations buying their shares back.

Physical gold sold off today, which pushed gold prices back down towards the bottom end of my ‘Buy Zone.’ If prices fail to hold here, the next stop is the low $1,220’s/oz. The gold and silver miners fell hard, as I was expecting them too. The large gold miners had high volume at the close, which could be people selling. I still believe both the gold and silver miners have one last move down, which is being validated by today’s price action.

  1. What happened to the stock market on Thursday?

The S&P 500 held the 2,800 level as Bears stood strong, but trading volumes collapsed and are only about half of what they normally should be. This will mark the fourth time stock prices attempted to push through 2,800 and I don’t expect it to be resolved in one day. I don’t read too much into the Nasdaq-100 setting a new all-time high because most of the money flowing in from corporate share buybacks are in the Nasdaq.

Treasury yields were down on the day, which is a change of pace. Normally yields have been rising on days stocks are up, so this is an indication the bond market isn’t seeing what the stock market is. The bond market is usually always on the right side of the market. The 30-year Treasury auction wasn’t overly strong but saw decent interest from foreign bidders.

Physical gold fell again but is looking for a potential double-bottom around $1,238/oz. I’m not convinced that will hold. The gold and silver miners tried to rally with stocks but found sellers. This is a good sign, as I have been expecting the miners to fall.

Agriculture commodities found buyers today. With prices at their 40+ year low, those looking to buy low and sell high will be attracted to this sector.

  1. What happened to the stock market on Friday?

The S&P 500 closed just over 2,800, but on very low volume. For reasons I can’t explain, trading volumes are expected to return to more “normal” levels after the World Cup ends on Sunday. Bond yields continue to move down as the bond market believes economic growth is likely to slow in the future. Physical gold fell back to its resistance level at $1,240/oz but is showing signs of another move down. A move down in gold should bring the mining stocks down into my targeted “Buy Zone,” which is the signal I’ve been looking for to take a position.

Portfolio Shield™ Update –

The monthly rebalance went smoothly and the allocation is still 100% equities. I am expecting the strategy to begin hedging with bonds starting in August unless stocks strongly rally.

The July 2018 Morningstar® Investment Detail Report is linked below.